UPTON COMPANY

Chapter Seven Mini Case Study

Points: 5

Name: _______________________________

Upton Company is a technology firm engaged in the manufacture and sale of innovative computer hardware components. Assume the following:

*The risk-free rate of return, R F, is 5%.

*The required rate of return on the market, r m, is 12%.

*The Upton Company's stock has a beta co-efficient of 1.2.

HINT: For each of the problems listed below: First use the Security Market Line (SML) equation (top of page 353 in the text) to solve for the required rate of return, r s, on Upton Company's stock. Then, use the Gordon constant growth model (at the center of page 303) to solve for the expected stock price, P o.

1. If the dividend expected during the coming year, D 1, is $2.00, and if g equals a constant 4%, at what price should Upton's stock sell?

a. SML variables: R F = _________%; r m = __________%; b = __________.

Solve the SML equation to find r s.

b. Gordon Model variables: D 1 = $ __________; g = _________%; r s = __________%**

**Note that r s is the solution to the SML equation just solved.

Solve the Gordon Model equation to find P o.

2. Now, suppose the Federal Reserve Board increases the money supply, causing the risk-free rate, R F, to drop to 3% and r m to fall to 10%. What would this do to the price of Upton Company's stock?

a. SML variables: R F = _________%; r m = __________%; b = __________.

Solve the SML equation to find r s.

Formula = Rs-rf+bx(Rm-rd)

0.05+1.2*(0.12-0.05)

0.05+1.2*(0.07)=0.05+0.084=0.134

13.4%

b. Gordon Model variables: D 1 = $ __________; g = _________%; r s = __________%**

**Note that r s is the solution to the SML equation just solved.

Solve the Gordon Model equation to find P o.

Formula -Po=d/RS-g

po=2/0.134-0.04

2/0.094=$21.27

THE UPTONS STOCKS WANT UP TO $21.27

3. In addition to the change in Question #2, suppose investors' risk aversion declines; this fact, combined with the previous decline in R F, causes r m to fall to 8%. At what price would Upton Company's stock now sell?

a. SML variables: R F = _________%; r m = __________%; b = __________.

Solve the SML equation to find r s.

b. Gordon Model variables: D 1 = $ __________; g = _________%; r s = __________%**

**Note that r s is the solution to the SML equation just solved.

Solve the Gordon Model equation to find P o.

4. Now, suppose Upton has a change in management. The new group institutes policies that increase the expected growth rate to 6%. Also, the new management stabilizes sales and profits, and thus causes the beta co-efficient to decline from 1.2 to 1.1. Assume that R F remains at 3% and r m remains at 8%. After all of these changes, what is Upton's new equilibrium price, assuming D 1 increases to $2.15?

a. SML variables: R F = _________%; r m = __________%; b = __________.

Solve the SML equation to find r s.

b. Gordon Model variables: D 1 = $ __________; g = _________%; r s = __________%**

**Note that r s is the solution to the SML equation just solved.

Solve the Gordon Model equation to find P o.