Quick Start Inc. is expected to pay a dividend of $1.05 next year and dividends are expected to continue their 7% annual growth rate. The SML has been estimated as follows:
K_j = 0.08 + 0.064β_j

Assuming Quick Start has a beta of 1.1, what would happen to its stock price if inflation expectations went from the current 5% to 8%?

Question

Quizplus · Accepted Answer

First, we need to find the required rate of return using the SML equation: K_j = 0.08 + 0.064(1.1) = 0.1504 or 15.04% Next, we can use the constant growth model to find the current stock price: P0 = D1 / (K_j - g) = $1.05 / (0.1504 - 0.07) = $12.03 If inflation expectations increase from 5% to 8%, we need to adjust the growth rate accordingly: g = 0.07 - 0.03 = 0.04 or 4% Now we can use the same constant growth model to find the new stock price: P1 = D2 / (K_j - g) = ($1.05 * 1.07) / (0.1504 - 0.04) = $11.48 The change in stock price is the difference between the new and old prices: Change in stock price = P1 - P0 = $11.48 - $12.03 = -$0.55 Therefore, the stock price would decrease by $0.55 or $3.55 (rounded to the nearest cent) if inflation expectations increased from 5% to 8%. The correct answer is B.