OldTime, Inc., is a mature firm operating in a very stable market. Earnings growth has averaged about 3.2% for the last dozen years, just staying in l... Accounting MCQs | Accounting MCQs

OldTime, Inc., is a mature firm operating in a very stable market. Earnings growth has averaged about 3.2% for the last dozen years, just staying in line with inflation. The firm’s weighted-average cost of capital is 8%, much lower than most firms. John Storms has just been hired as OldTime’s new CEO and wants to turn what he calls a “cash cow” into a “growth company.” Storms wants to reduce the dividend pay-out and use the resulting retained earnings to fund the firm’s expansion into new product lines. OldTime’s historical beta has been about . . With the CEO’s changes, what will most likely happen to OldTime’s beta and the required return on investment in its shares?

The beta will fall, and the required return will rise.
The beta will fall, and the required return will fall.
The beta will rise, and the required return will fall.
The beta will rise, and the required return will rise.Show Result

Correct - Your answer is correct.

Wrong - Your answer is wrong.

Detailed Answer

Answer (D) is correct. The required rate of return is equal to the risk-free return plus the beta times the market return less the risk-free return. If OldTime starts expanding into new product lines, the historical beta will increase, as the company will be taking on more risk with these new changes and investments. This will also increase the required rate of return, as per the formula.