The current dividend, D0, of the stock of Sun Devil Corporation is $3 per share. Under present conditions, this dividend is expected to grow at a rate of 6 percent annually for the foreseeable future. The beta of Sun Devil stock is 1.5. The risk-free rate of return is 7 percent and the expected market rate of return is 14 percent.
a. At what price would you expect Sun Devil common stock to sell?
b. If the risk-free rate of return declines to 6 percent, what will happen to Sun Devil's stock price? (Assume that the expected market rate of return remains at 14 percent.)
c. Sun Devil's management is considering acquisitions in the machine tool industry. Management expects the firm's beta to increase to 1.6 as a result of these acquisitions. The dividend growth rate is expected to increase to 7 percent annually. Would you recommend this acquisition program to management? (Assume the same initial conditions that existed in part a.)