Lotte Group is planning on diversifying into the transportation industry. As a result, Lotte's...

Question:

Lotte Group is planning on diversifying into the transportation industry. As a result, Lotte's beta would rise to 1.3 from 1.1 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?

The Dividend Growth Model:

Stock valuation is an important part of the company's strategic policies. When the company needs to make strategic decisions for expansions or otherwise, it is important to understand how the decision would impact the company's market valuation. One of the common methods of stock valuation is the dividend growth model.

Answer and Explanation:


Let us compute the expected rate of return and current stock price:


Under the CAPM model, the expected rate of return on equity {eq}R_{e} = R_{f} + \beta (R_{p}) {/eq}

Where {eq}R_{e} {/eq} stands for expected rate of return


{eq}R_{f} {/eq} stands for the risk-free rate


{eq}R_{p} {/eq} stands for the market premium rate


{eq}\beta {/eq} stands for the beta.

Given, risk-free rate = 5%

Market risk premium= 8.6%

Beta = 1.3

So, the expected rate of return {eq}R_{e} {/eq} = (0.05 + 1.3 (0.086)) = 0.1618 or 16.18%

Stock value under the dividend growth model:

The market value of stock = {eq}\frac{d_{1}}{R_{e}-g} {/eq}

Where {eq}d_{1} {/eq} stands for the current dividend

and

g stands for the expected growth rate.

Given, current dividend = $1.30

Expected growth rate = 11%

Expected rate of return (calculated) = 16.18%

Stock value = {eq}\frac{1.30}{(0.1618 - 0.11)} {/eq} = $25.10

So, the current stock price = $25.10


Now let us compute revised expected rate of return and the new stock price:


Revised expected rate of return = {eq}R_{e} = R_{f} + \beta (R_{p}) {/eq}

Given, risk-free rate = 5%

Market risk premium= 8.6%

Revised Beta = 1.1

So, the expected rate of return {eq}R_{e} {/eq} = (0.05 + 1.1 (0.086)) = 0.1446 or 14.46%

Stock value under the dividend growth model:

The market value of stock = {eq}\frac{d_{1}}{R_{e}-g} {/eq}

Where {eq}d_{1} {/eq} stands for the current dividend

and

g stands for the expected growth rate.

Given, current dividend = $1.30

Revised expected growth rate = 14%

Expected rate of return (calculated) = 14.46%

Stock value = {eq}\frac{1.30}{(0.1446 - 0.14)} {/eq} = $282.61

So, the new stock price = $282.61

Since the new stock price is higher than the current stock price by $257.57 ($282.61 - $25.10), the company shall diversify into the transportation industry.


Learn more about this topic:

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The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
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