Question

PhillyDogCare is currently selling at $150 per share. The firm’s ROE is 20% and its market capitalization rate is 15%. If the company decides to increase its plow back rate from 60% to 80%, what would you expect of the company’s stock price?

a) Price will increase because investors will correctly anticipate that PhillyDogCare’s dividends will grow at a faster rate with a smaller payout ratio

b) Price will drop because many investors will be upset about much lower future dividends

c) Price will increase because the firm will invest in more positive NPV projects

d) Both A and C

e) Not enough information

Answer 1

Plow back ratio is opposite of dividend payout ratio, it indicates the amount that company is investing back in its business after paying out dividends. The formula for the same is as follows:

Plow Back ratio = 1 - (Annual dividend per share / Earnings per share)

A higher plow back ratio indicates that the firm will retain more of its earnings than distributing the same to its shareholders. Under such case, the ROE ratio can tell a better picture of a company's stock price in future. If the ROE is better than the market capitalization rate, then it indicates that retaining money will generate higher return on the money that is retained than to give away such money to shareholders in the form of dividends.

In this case, the ROE of company is 20%, which is higher than the market capitalization rate, hence company would generate a return of 20% on the extra amount which will be plow backed into business. Therefore, the correct answer to the question is c) 'Price will increase because the firm will invest in more positive NPV projects'