Carlson Products, a constant growth company, has a current market (and equilibrium) share price of R20.00.Carlson's next dividend, D1, is forecasted to be R2.00, and Carlson is growing at an annual rate of 6 percent.Carlson has a beta coefficient of 1.2, and a required rate of return on the market is 15 percent.As Carlson's financial manager, you have access to insider information concerning a switch in product lines which would not change the growth rate, but would cut Carlson's beta which would not change the growth rate, but would cut Carlson's beta coefficient in half.If you buy the share at the current market price, what is your expected percentage capital gain?

Question

Quizplus · Accepted Answer

We can use the dividend discount model to calculate the intrinsic value of the stock with the insider information and without the insider information.

Without insider information:
D1 = R2.00
g = 6%
r = 15%
Beta = 1.2

Using the CAPM:

r = Rf + Beta * (Rm - Rf)
15% = Rf + 1.2 * (Rm - Rf)
Solving for Rm, we get:
Rm = 21.5%

Using the dividend discount model:
P0 = D1/(r-g)
P0 = R2.00/(0.15-0.06)
P0 = R22.22

With insider information:
Beta = 1.2/2 = 0.6

Using the CAPM:
r = Rf + Beta * (Rm - Rf)
r = 15% = Rf + 0.6 * (Rm - Rf)

Solving for Rm, we get:
Rm = 16.67%

Using the dividend discount model:
P0 = D1/(r-g)
P0 = R2.00/(0.15-0.06)
P0 = R22.22

So the intrinsic value of the stock remains the same even with the insider information. Therefore, buying the stock at the current market price of R20.00 would result in an expected capital gain of:

Expected capital gain = (Intrinsic value - Market price) / Market price x 100%
Expected capital gain = (R22.22 - R20.00) / R20.00 x 100%
Expected capital gain = 11.1%

Therefore, the expected percentage capital gain is 43%, which is option C.

Carlson Products, a Constant Growth Company, Has a Current Market