Question

Lawrence Industries’ most recent annual dividend was $1.80 per share (D0 = $1.80). The company expects its dividend to grow at 8% annually for next 3 years, followed by a 4% constant annual growth rate in years 5 to infinity. Market data indicates a beta of 1.25 for Lord of Chips. The expected return on the market portfolio is 9%
You are required to;
(i) Calculate the required rate of return for Lawrence Industries’ shares using the CAPM assuming a risk-free rate of 5%. (1 Point)
(ii) What is the maximum price per share that Lawrence Industries should set for ordinary shares if the company have plan to make a new share issue? (4 Points)

(iii) If Lord of Chips’ shares are traded in the market at $38.50 what would be your recommendation to Lawrence Industries on their proposed share issue? Justify your answer. (1 Point)
(iv) 'The price of a financial asset in the market is depend on the degree of market efficiency'. Briefly explain the three level of market efficiency. (2 Points)

Answer 1

(i)

As per CAPM required return = risk free rate + beta*(market return - risk free rate)

= 5% + 1.25*(9% - 5%)

Ke = 10%

(ii)

using dividend discount model price of the share will be as follows:

D1 = 1.80*(1+8%) = 1.944

D2 = 1.944*(1+8%) = 2.10

D3 = 2.10*(1+8%) = 2.2675

D4 = 2.2675*(1.04) = 2.3582

price in year 3 = D4 / Ke - g

= 2.3582 / (10% - 4%)

= 39.30

current price = (1.944/1.10) + (2.10 / 1.10^2) + (2.2675 + 39.30) / 1.10^3

= $34.73

(iii)

As per the dividend discount model shares are worth $34.73.if shares are traded at $38.50 they are overpriced in market.

(iv)

three levels of market efficiency are

1)weak efficient market hypotheses

2) semi strong market hypotheses

3) strong market hypotheses

in weak form stock prices depends on historical financial performance and past price movements of the stock

semi strong hypotheses states that stock price does not depend on past prices and technical analysis because the information is already known to public and already accounted for.stock price movements depends only on information that is not known to public.

in strong form, price movements neither depends on technical analysis  nor on information not available to public.it says that stock prices already accounted for both the above.