Philadelphia Corporation's stock recently paid a dividend of $2.00 per share (D₀ = $2),and the stock is in equilibrium.The company has a constant growth rate of 5 percent and a beta equal to 1.5.The required rate of return on the market is 15 percent,and the risk-free rate is 7 percent.Philadelphia is considering a change in policy which will increase its beta coefficient to 1.75.If market conditions remain unchanged,what new constant growth rate will cause the common stock price of Philadelphia to remain unchanged? A) 8.85% B) 18.53% C) 6.77% D) 5.88% E) 13.52%

Question

Quizplus · Accepted Answer

Using the constant growth model,
Current stock price (P0) = Dividend / (required rate of return - growth rate)
P0 = $2 / (0.15-0.05) = $20
After the change in policy, the new required rate of return will be:
0.07 + 1.75(0.15 - 0.07) = 0.22
We want the new stock price (P1) to remain unchanged at $20, so we can use the same equation and solve for the new growth rate:
P1 = $2 (1 + g) / (0.22 - g)
$20 = $2 (1 + g) / (0.22 - g)
10.1 - 10g = 1 + g
9g = 9.1
g = 0.677 or 6.77%
Therefore, the answer is C.

Philadelphia Corporation's Stock Recently Paid a Dividend of $2