Suppose Chance Chemical Company’s management
conducted a study and concluded that if it expands its consumer products division (which is less risky than its primary business, industrial chemicals), its beta will decline from 1.2 to 0.9. However, consumer products have a somewhat lower profit margin, and this would cause its constant growth rate in earnings and dividends to fall from 6% to 4%. The following also apply: r_M = 9%, r_RF = 6%, and D₀ = $2.00.
a. Should management expand the consumer products division? Explain.
b. Assume all the facts given except the change in the beta coefficient. How low would the beta have to fall to cause the expansion to be a good one? (Hint: Set P^'₀ under the new policy equal to P^'₀ under the old one, and find the new beta that will produce this equality.)