Question

You should know the formula for the share price for the dividend growth formula. For example, if Div1 = EPS what is the formula for the share price? what happens to share price if MM Propositions I and II without taxes hold.

Answer 1

As per Gordon growth formula,

Shar price (P0) = Dvivdend at year 1 (D1) / [Cost of equity capital (Ke) - Growth rate (g)]

i.e., P0 = D1 / [ Ke - g ]

In this case, D1 = EPS

Therefore, P0 = EPS / [ Ke - g ]

MM Proposition I without taxes says that a firm's relative proportions of debt and equity don't matter. The value of equity remains the same irrespective of the capital structure of the firm. Therefore, share price remains the same.

MM Proposition II deals with the WACC. It says that as the proportion of debt in the company's capital structure increases, its return on equity to shareholders increases in a linear fashion. The existence of higher debt levels makes investing in the company more risky, so shareholders demand a higher risk premium on the company's stock. However, because the company's capital structure is irrelevant, changes in the debt-equity ratio do not affect WACC. Therefore, share price remains the same.