INSTRUCTOR: Mr. Konstantinos Kanellopoulos, MSc (L.S.E.), M.B.A.

COURSE: FIN-210-50-S13 Finance

SEMESTER: II, 2013

Tutorial 3 – for tutor

INSTRUCTIONS

Students are required to study the following questions and problems indicated and to be
able to solve them by themselves.

Although this is not a required part of a coursework, the purpose of the tutorial is
twofold: to help the student understand the methodology for solving the problems and to
help him/her prepare for the courseworks and/or exams. The utilisation of this resource
can be maximised depending on the time and effort each individual student devotes.

Konstantinos Kanellopoulos
2nd April 2013
 Valuation Concepts

Problem 3
The risk-free rate of return, kRF, is 11 percent; the required rate of
return on the market, kM, is 14 percent; and Gerlunice Company’s stock
has a beta coefficient, β, of 1.5.

a. Based on the capital asset pricing model (CAPM), what should be the required return
for Gerlunice Company’s stock?

b. If the dividend expected during the coming year, D̂1 is $2.25, and g = 5% and is
constant, at what price should Gerlunice’s stock sell?

c. Now suppose the Federal Reserve Board increases the money supply, causing the
risk-free rate to drop to 9 percent and kM to fall to 12 percent. What would this do to
the price of the stock?

d. In addition to the change in part c, suppose investors’ risk aversion declines; this fact,
combined with the decline in kRF, causes kM to fall to 11 percent. At what price would
Gerlunice’s stock sell?

e. Now suppose Gerlunice has a change in management. The new group institutes
policies that increase the expected constant growth rate to 6 percent. Also, the new
management stabilizes sales and profits, which causes the beta coefficient to decline
from 1.5 to 1.3. Assume that kRF and kM are equal to the values in part d. After all
these changes, what is Gerlunice’s new equilibrium price? (Note: D̂1 goes to $2.27).

Solution:

a. ks = kRF + (kM - kRF)βs = 11% + (14% - 11%)1.5 = 15.5%

b. P0 = D̂1 / (ks - g) = $2.25/(0.155 - 0.05) = $21.43.

c. ks = 9% + (12% - 9%)1.5 = 13.5%; P0 = $2.25/(0.135 - 0.05) = $26.47

d. ks = 9% + (11% - 9%)1.5 = 12.0%; P0 = $2.25/(0.12 - 0.05) = $32.14

e. According to the change in management: kRF = 9%; kM = 11%; g = 6%, βs = 1.3

ks = kRF + (kM - kRF)βs = 9% + (11% - 9%)1.3 = 11.6%

D0 = $2.25/1.05 = $2.14

2
P0 = D̂1 /(ks - g) = [$2.14(1.06)]/(0.116 - 0.06) = $2.27/0.056 = $40.54