Question

If a firm's required rate of return equals the firm's retuen on equity, there is no advantage to increasing the firm's growth. Suppose a no-growth firm had a required ratw of return and a ROE of 12%, and the dividends just paid out were $4.80 per share ( i.e. a no-growth firm would typically pay all of its eaenings as dividends).

However, the firm CFO just announced that he expects that the firm will be able to increase the DOE to 15% and will change the dividend payout to 40% of earnings. This is bot expected to change the required rate of return and earnings 1 year from now are expected to stay at $4.80 per share before the change take effect.

What is the price of the stock before the CFO's announcement?

What would be the proce of the stock after CFO's announcement?

Answer 1

Given dividend before cfo announcement =4.80

For a constant dividend paying company i.e no growth company price of stock is given as

Dividend /required rate of return

Hence price of stock =4.80/12%

=40

There for price before announcement =4.80

After announcement

Earnings for next year =4.80

Dividend payout ratio =40%

Dividend for next year =40% of 4.80= 1.92

Since compamy will retain 60% of earning and the Roe will be 15%

Hence sustainable growth is given as = retention ratio* ROE

=60%*15%= 9%

Also given the required rate of return will not change

Hence for a dividend growth model

Price of stock is given as = dividend for next year / (required rate of return-growth)

=1.92/(12%-9%)

=64

Hence the price after cfo announcement shall be 64