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Problem: IDX industries is an all equity firm with no outstanding debt. Current earnings are £5 per share. Under its current policies, IDX pays out all of its earnings as dividends and has no expected growth in earnings per share. IDX's stock return has a correlation of 0.40 with the market portfolio and an annual standard deviation of 30%. Assume the market portfolio has the expected return of 8% and standard deviation of 20%. The annual risk-free rate of return is 3%.
Assume perpetuity cash flows.
Required:
Question 1: Calculate the current stock price of IDX.
Question 2: IDX has a new investment opportunity which will require that 50% of all earnings are reinvested each year, and which will permanently increase its return on equity to 10%. At the moment the stock market is unaware that IDX has this new investment opportunity but the board of directors plans to announce it soon. What will be the change in IDX's stock price once the news is announced?
Question 3: Briefly explain how your analysis in (b) depends upon efficient markets theory.
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