Question 1: Olter’s Beta coefficient
Olter’s Beta can be determined using the Capital Asset Pricing Model. The required return on the average stock is the market return while the average return on Olter’s stock is Olter’s required rate of return.
Beta = (Expected return – Risk-free rate)/ (Market return – Risk free rate)
= (13-6)(13-6)
= 1.0
Question 2: Effect of Beta coefficient on stock price
Beta is a measure of risk and gives the variability of a stock’s return (price changes) in relation to the variability of the overall market. Since it represents the stock’s risk, Beta influences the prices of stocks. Under the Capital Asset Pricing Model, Beta is used to determine the required return on a stock. The require rate on a stock is the cost of capital (equity) and denotes the minimum return shareholders can accept from an investment in the stock (Brigham & Ehrhardt, 2013). From the model, we can conclude that there is a positive relationship between Beta and its required rate of return on a stock. If the stock’s Beta is high, it implies the risk is high hence investors will demand a greater return to offset the increased risk. The assumption, in this case, is that investors are rational and risk-averse hence they require an additional return for additional risk.
One of the most widely used approaches for of valuing stocks is the dividend model where the present value of a stock is determined by calculating the present value of dividends expected from the stock. In this method, the cost of equity is used as the discount factor. There is always an inverse relationship between the present value of a sum and the discount rate. A higher discount rate implies a higher risk on the expected cash flows. Therefore, the present value decreases if the discount rate/the cost of equity is high (Brigham & Ehrhardt, 2013). Thus, if the Beta of a stock is high, its value will be lower since the cost of equity will be high. A decline in Beta reduces the cost of equity thus increasing the price of the stock.
Question 3: Required rate of return on Olter’s stock
= 6% + 1 (13 – 6)
= 6% + 7%
= 13%
The required return on Olter’s stock is equal to the average market return. The Capital Asset Pricing Model assumes that systematic risk, as measured by Beta, is the only determinant of a stock’s required rate of return. This implies that stocks with similar values of Beta should have the same required rate of return and that any differences in the required rates of return of different stocks are explained by the differences in the values of their Beta. In this case, Olter’s Beta coefficient is 1.0 indicating that is the same as the market’s beta coefficient. Therefore, the required rate of return on Olter’s stock should be equal to that of the average stock (market return).
Question 4: comparison between Olter’s risk and average market risk
Beta is the measure of variability of a stock’s return in relation to the variability of the average market’s return (Moles, 2011). It is one of the key factors considered by investors in evaluating a stock for investment. Beta measures a stock’s systematic risk. Systematic risk refers to the variability of a stock’s returns caused by market-wide factors. These factors affect the overall market and not specific to certain industries or sectors. Therefore, systematic risk cannot be eliminated through diversification. Unsystematic risk, on the other hand, is the variability of returns of a stock caused by factors specific to an industry or firm such as labour strikes, among others. They do not affect the entire market hence can be eliminated through diversification. Since unsystematic risk can be eliminated by creating a well-diversified portfolio, investors do not consider in evaluating stocks for investment purposes (Moles, 2011).
The Beta for the average market is usually taken 1.0. The beta for individual stocks can be used to compare the stock’s risk with the market risk. If a stock’s Beta is more than 1.0, it implies that the stock’s risk is greater than that of the average market (Moles, 2011). For instance, if Beta of a stock 1.2 means that its risk is 20% more than that of the market. This indicates that if a change in a market-wide factor causes a 1% variability in average market return, the same change will cause a 1.2% variability in the returns on the stock.
If the Beta of a stock is less than 1.0, it implies that the stock’s risk is less than the average market risk. For instance, a Beta of 0.5 indicates that if a variation in a market-wide variable such as interest rate causes a 1% variation in the average market return, the stock will experience a 0.5% variation in its return. When the stock has the same Beta as that of the average market, it implies that its risk is equal to that of the average market. Thus, a 1% variation in the average market return causes a 1% variation in the stock’s return.
In this case, Olter has a Beta coefficient of 1.0. This is equal to the Beta coefficient of the average market indicating that it has the same systematic risk as the average market. If the average market return varies by 1% as a result of a change in interest rate, the return on Olter’s stock will also vary by 1%. Since Olter has the same risk as the average market, it implies that its required rate of return must be equal to that of the average market. The above calculation shows that Olter’s expected rate of return is 13% which is also the return on the average stock.
Question 5: Required return if Beta increases to 1.6
If the Beta for Olter’s increase to 1.6, I would expect the required rate of return to increase. As discussed above, an increase in Beta implies a rise in the stock’s systematic risk hence the expected return must increase. The Capital Asset Pricing Model provides that investors are risk-averse and would demand an additional return for risks higher than the normal level. Investors require the risk-free rate plus the risk premium. The risk-premium compensates an investor for the risk above the risk-free level (Brigham & Ehrhardt, 2013). Risk premium is the product of Beta and the difference between the risk-free rate and the average market return. An increase in Beta increases the risk premium thereby increasing the required return. The new required rate on Olter’s stock will be as follows:
= 6% + 1.6 (13 – 6)
= 6% + 11.2
= 17.2%
As shown above, the increase in Beta from 1.0 to 1.6 causes an increase in the required rate of return on Olter’s stock from 13% to 17.2%. The risk premium increases from 7% to 11.2%.
Implications of the increase in Beta to Olter
The above increase in Beta coefficient for Olter’s stock has several implications to the firm. Firstly, it results in the increase in the required rate of return on the stock (Moles, 2011). This means that the firm must earn a higher return for shareholders. The discount rate also increases thereby reducing the stock’s price. The reduction in the stock’s price could be detrimental if not checked. In efficient stock markets, investors believe that movements in prices reflect the past, current and future information about the firm’s performance. Therefore, a decline in the stock price may be construed as a future decline in the firm’s performance. Investors may engage in panic sales to avoid further losses thereby reducing the stock’s price further. Diversification of revenues/products, stock splits, among other measures can also assist in reducing the volatility of the stock’s price.
The firm must place measures to improve profitability to enhance the price of the stock. Paying dividends can help increase the stock’s price. Therefore, Olter must generate adequate earnings to enable it to pay better dividends. This may require a review of the firm’s dividend policy to ensure that it pays dividends consistently (Moles, 2011). An increase in dividends increases the cash flows expected from a stock thereby causing an increase in the stock’s price. The company can also resort to other measures of stabilising the form’s price such as repurchasing its stock. A stock repurchase would lower the supply of Olter’s stock in the market thus increasing its price.
The increase in the cost of equity can also have implications on financing decisions. A rise in the cost of equity makes it economical to use debt financing if the cost of debt is lower. Managers must consider the opportunity cost of funding by comparing the cost of different financing alternatives (Moles, 2011). If the cost of equity is high, Olter may resort to financing its projects and other operations through borrowing. This can increase the firm’s leverage.
Besides, the increase in Beta has an effect on investment decisions. Capital budgeting involves assessing the viability of projects to justify financing. Investment appraisal techniques are used to determine the value of a project and determine whether it is viable for investment or not. The most used techniques are the discounting methods in which the expected cash flows from the project are discounted at the cost of capital. The cost of capital/discount rate has a great impact on the present values of expected cash flows (Brigham & Ehrhardt, 2013). An increase in the discount rate causes a decline in the present values of cash flows. This implies that projects will now have to generate more cash flows to be considered for investment. The management of Olter will require a higher rate of return from projects. For instance, if the management is using the IRR technique, an investment must generate a return of at least 17.2% to be considered for funding. The effect is that viable projects may be rejected due to the high required rate of return.
References
Brigham, E., & Ehrhardt, M. (2013). Financial Management: Theory & Practice (14th ed.). New York: Cengage Learning.
Moles, P. (2011). Corporate finance. Hoboken, N.J.: Wiley.
