Lotte Group is planning on diversifying into the transportation industry. As a result, Lotte's beta would rise to 1.3 from 1.1 and the expected long-term growth rate in the firm's earnings would increase from 11% to 14%. Currently the risk-free rate is 5.0% and the market risk premium is 8.6%. If Lotte's current dividend is $1.30, should Lotte diversify into the transportation industry?
A) No, stock price does not increase.
B) No, stock price declines about $10.11.
C) Yes, stock price increases about $19.42.
D) Yes, stock price increases by about $26.27.

Question

Quizplus · Accepted Answer

First, we need to calculate the expected return on Lotte's stock before and after the diversification:

Before diversification:
Cost of equity = Risk-free rate + Beta * Market risk premium
Cost of equity = 5% + 1.1 * 8.6%
Cost of equity = 14.46%
Expected return = Dividend / (Cost of equity - Growth rate)
Expected return = 1.30 / (14.46% - 11%)
Expected return = 12.08%

After diversification:
Cost of equity = Risk-free rate + Beta * Market risk premium
Cost of equity = 5% + 1.3 * 8.6%
Cost of equity = 16.18%
Expected return = Dividend / (Cost of equity - Growth rate)
Expected return = 1.30 / (16.18% - 14%)
Expected return = 14.44%

Next, we need to calculate the stock price before and after the diversification:

Before diversification:
Stock price = Dividend / (Cost of equity - Growth rate)
Stock price = 1.30 / (14.46% - 11%)
Stock price = $49.62

After diversification:
Stock price = Dividend / (Cost of equity - Growth rate)
Stock price = 1.30 / (16.18% - 14%)
Stock price = $75.89

Therefore, the stock price would increase by $26.27 if Lotte diversifies into the transportation industry. The best choice is D: Yes, stock price increases by about $26.27.

Lotte Group Is Planning on Diversifying into the Transportation Industry