Mahlo is planning to diversify into the bakery industry. As a result, its beta should drop from 1.4 to 1.2 and the expected long-term growth rate of dividends will drop from 12% to 9%. The risk-free rate is 4%, the expected market risk premium is 9%, and the current dividend per share paid by Mahlo is $2.10. Should Mahlo complete the diversification into the bakery industry?

Question

Quizplus · Accepted Answer

Before diversification, Mahlo's required rate of return (using CAPM) is: 4% + 1.4(9%) = 16.6%. The growth rate is 12%, so using the Gordon Growth Model, the stock price is: $2.10 / (0.166 - 0.12) = $52.50. After diversification, the required rate of return is: 4% + 1.2(9%) = 14.8%. The new growth rate is 9%, so the new stock price is: $2.10 / (0.148 - 0.09) = $41.80. The difference is $52.50 - $41.80 = $10.70, which is approximately $11.70 drop.

Mahlo Is Planning to Diversify into the Bakery Industry