Question
Upton Company is a technology firm engaged in the manufacture and sale of innovative computer hardware components. Assume the following: *The risk-free rate of return,
Upton Company is a technology firm engaged in the manufacture and sale of innovative computer hardware components. Assume the following:
*The risk-free rate of return, R F, is 5%.
*The required rate of return on the market, r m, is 12%.
*The Upton Company's stock has a beta co-efficient of 1.2.
HINT: For each of the problems listed below: First use the Security Market Line (SML) equation (top of page 318 in the text) to solve for the required rate of return, r s, on Upton Company's stock. Then, use the Gordon constant growth model (at the bottom of page 270) to solve for the expected stock price, P o.
1. If the dividend expected during the coming year, D 1, is $2.00, and if g equals a constant 4%, at what price should Upton's stock sell?
a. SML variables: R F = _________%; r m = __________%; b = __________.
Solve the SML equation to find r s.
b. Gordon Model variables: D 1 = $ __________; g = _________%; r s = __________%**
**Note that r s is the solution to the SML equation just solved.
Solve the Gordon Model equation to find P o.
2. Now, suppose the Federal Reserve Board increases the money supply, causing the risk-free rate, R F, to drop to 3% and r m to fall to 10%. What would this do to the price of Upton Company's stock?
a. SML variables: R F = _________%; r m = __________%; b = __________.
Solve the SML equation to find r s.
b. Gordon Model variables: D 1 = $ __________; g = _________%; r s = __________%**
**Note that r s is the solution to the SML equation just solved.
Solve the Gordon Model equation to find P o.
3. In addition to the change in Question #2, suppose investors' risk aversion declines; this fact, combined with the previous decline in R F, causes r m to fall to 8%. At what price would Upton Company's stock now sell?
a. SML variables: R F = _________%; r m = __________%; b = __________.
Solve the SML equation to find r s.
b. Gordon Model variables: D 1 = $ __________; g = _________%; r s = __________%**
**Note that r s is the solution to the SML equation just solved.
Solve the Gordon Model equation to find P o.
4. Now, suppose Upton has a change in management. The new group institutes policies that increase the expected growth rate to 6%. Also, the new management stabilizes sales and profits, and thus causes the beta co-efficient to decline from 1.2 to 1.1. Assume that R F remains at 3% and r m remains at 8%. After all of these changes, what is Upton's new equilibrium price, assuming D 1 increases to $2.15?
a. SML variables: R F = _________%; r m = __________%; b = __________.
Solve the SML equation to find r s.
b. Gordon Model variables: D 1 = $ __________; g = _________%; r s = __________%**
**Note that r s is the solution to the SML equation just solved.
Solve the Gordon Model equation to find P o.
***Please fill in the blanks so it's easier to follow, thank you!!
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