2. Measuring Expected Return Assume Mess stock has a beta of 1.2. If the risk-fr

Question

2.            Measuring Expected Return Assume Mess stock has a beta of 1.2. If the risk-free rate is 7 percent and the market return is 10 percent, what is the expected return of Mess stock?

Recall that if the economy continues to be strong, Carson Company may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It would need financing to expand and accom- modate the increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. It is also considering issuing stock or bonds to raise funds in the next year. If Carson goes public, it might even con- sider using its stock as a means of acquiring some target firms. It would also consider engaging in a secondary offering at a future point in time if the IPO is successful and if its growth continues over time. It would also change its compensation system so that most of its man- agers would receive about 30 percent of their compensa- tion in shares of Carson stock and the remainder as salary.

a.            At the present time, the price–earnings ratio (stock price per share divided by earnings per share) of other firms in Carson’s industry is relatively low but should rise in the future. Why might this information affect the time at which Carson issues its stock?

b.            Assume that Carson Company believes that issuing stock is an efficient means of circumventing the potential for high interest rates. Even if long-term interest rates have increased by the time it issues stock, Carson thinks that it would be insulated by issuing stock instead of bonds. Is this view correct?

c.            Carson Company recognizes the importance of a high stock price at the time it engages in an IPO (if it goes public). But why would its stock price be important to Carson Company even after the IPO?

d. If Carson Company goes public, it may be able to motivate its managers by granting them stock as part of their compensation. Explain why the stock may moti- vate them to perform well. Then explain why the use of stock as compensation may motivate them to focus on short-term goals even though they are supposed to focus on maximizing shareholder wealth over the long run. How can a firm provide stock as motivation but prevent its managers from using a short-term focus?

Explanation / Answer

Expected Return =7% + 1.2 x (10-7)% = 10.6% Question a. Price earnings ratio low means return on common stock is lower. This might effect its IPO badly. Question b. Cost of own capital is higher than cost of loan Capital. This is due to the tax implecation. Interest on Loan is tax deductible, where profit on common stock are not deductable for tax purpose. Question c. Stock price will be important because it will help investor to receive gain from the increased price. On the other hand Carson company can also offer issue of stock at a higher price and which in turn enable the company gain owners equity. Question d. Main purpose of issue of stock to managers are (a) to stop cash outflows, b) Make the managers feel that they are also the owner of the company and will be able to participate in the income. Managers also feel that they may make capital gain income from those stock if company perform better and produce better result.

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