Question

Suppose Chance Chemical Products management conducts a study and concludes that if it expands into a consumer products division (which is less risky than its primary business of industrial chemicals), the firm's beta would decline from 1.2 to 0.9.  However consumer products have a somewhat lower profit margin, and this would cause Chance's constant growth rate in earnings and dividends to fall from 7 to 5 percent. Should management undertake this change assuming that the average market return is 12% will the rate on Treasury notes is 9%?  Chance has just paid a dividend of $2.

Write your recommendation taking into account some of the general issues involved in the assessment (eg. principles involved in company diversification, estimation of beta's etc.)

Answer 1

Answer)

• Since company capital structure is not mention we are concidering Beta equity and Beta asset same.
• Using an assumption that CAPM and divident discount model give same results
• Tax effect is been neglected as tax in not mention
• Assumption that Stock price will remain sticky in short term, which might not be true as the news of diversification will go out, investors perception about business viability will change

Current Beta = 1.2

Divident = $2

Current growth rate = 7%

Average Market return = 12%

tresury notes return = 9%

Using CAPM

ke = 9 + 1.2*(12-9)

ke = 12.6

Using Divident Discount model to get current stock price

= $ 38.21

Now if company takes on new diversified business then divident growth rate will be 5%

New cost of equity

ke = 10.49%

Using CAPM we again find beta

Beta new = 0.496

Recommendation

yes company should go for this diversification as it will reduce its beta to a lower value than predicted 0.9 which makes business less risky and volatile, but firm will also loss the benefits of high profit in favourable business cycle as its beta is reducing, it will make investors assured for small but perpetual dividents