4. In March 2015, the Value Line Investment Survey reported the following market

Question

4. In March 2015, the Value Line Investment Survey reported the following market betas for W$D, HLA, United Pharma, and Great Reasonable Efficient and Effervescent Drug, Inc:      

Company

Beta

Healthy Lives for All

0.9

We$ellDrugs

1.2

Great Reasonable Efficient and Effervescent Drug

1.5

United Pharma

1.7

Risk free rate

6.50%

Required rate of return on market

13.50%

At the time these betas were developed, reasonable estimates for the risk-free rate, RF, and the required rate of return on the market, R(Rm), were 6.5 percent and 13.5 percent, respectively. (a & b: 4 points each; c & d: 9 points each)

a. Using the SML/CAPM model what are the required rates of return on the four stocks?   

b. Why do their required rates of return differ?                                                              

c. If the outcome of the congressional hearings into W$D pricing yields regulated prices what do you expect would happen to W$D’s stock price? Why? Explain the mechanism using steps similar to those on Q3e.

d. If reulated prices were binding for 10 years, what would you expect to happen to W$D’s beta? Why? (Hint: Why do estimates of a firms future earnings vary?)

Company

Beta

Healthy Lives for All

0.9

We$ellDrugs

1.2

Great Reasonable Efficient and Effervescent Drug

1.5

United Pharma

1.7

Risk free rate

6.50%

Required rate of return on market

13.50%

Explanation / Answer

The Required rate of retuen as per CAPM/SML = Risk free rate + ( Return on market - Risk free return) * Beta

Return on Market - Risk free return = 13.5 - 6.5 = 7%

a. Required rate of return :

Healthy Lives = 6.5 + 7 * 0.9 = 12.8%

Weselldrugs = 6.5 + 7 * 1.2 = 14.9%

GREED = 6.5 + 7 * 1.5 = 15.5%

United = 6.5 + 7 *1.7 = 18.4%

b. The rate of return is different because of different Beta of each stock. i.e they have different sensitivity with the market.

c.If regulatory price applies, then required rate of return for WSD will go up.

d. If regulated prices go up for 10 years, then beta would increase, hence leading to permanent increase in Required rate of Return.

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