Question

DFB, Inc. expects earnings next year of $5.53 per share, and it plans to pay a $3.05 dividend to shareholders (assume that is 1-year from now). DFB will retain $2.48 per share of its earnings to reinvest in new projects that have an expected return of 15.1% per year.

Suppose DFB will maintain the same dividend payout rate, retention rate, and return on new investments in the future and will not change its number of outstanding shares. Assume next dividend is due in one year.

a. What growth rate of earnings would you forecast for DFB?

1. 2.3%

2. 3.4%

3. 4.5%

4. 5.6%

5. None of the above

b. If DFB's equity cost of capital is 11.1% and growth rate is 6.8%, what price would you estimate for DFB stock?

1. $47.60

2. $58.71

3. $69.82

4. $70.93

5. None of the above

c. Suppose instead that DFB paid a dividend of $4.05 per share at the end of this year and retained only $1.48 per share in earnings. That is, it chose to pay a higher dividend instead of reinvesting in as many new projects. If DFB maintains this higher payout rate in the future, what stock price would you estimate for the firm now? Should DFB raise its dividend?

1. $57.04, DFB should raise dividends because it will result in a higher stock price.

2. $57.04, DFB should not raise dividends because it will result in a lower stock price.

3. $60.25, DFB should not raise dividends because it will not result in a higher stock price.

4. $68.15, DFB should raise dividends because it will result in a higher stock price.

5. $68.15, DFB should not raise dividends because it will not result in a higher stock price.

Answer 1

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