Question

Question 5 The stock of Elf Corporation is currently selling for $10 per share. Earnings per share in the coming year are expected to be $2. The company has a policy of paying out 50% of its earnings each year in dividends. The rest is retained and invested in projects that earn a 20% rate of return per year. This situation is expected to continue indefinitely. a. Assuming the current market price of the stock reflects its value, what rate of return do Elf’s investors require?

b. By how much does its value exceed what it would be if all earnings were paid as dividends and nothing was reinvested?

c. What is the PVGO for this company?

d. If Elf were to cut its dividend payout ratio to 25%, what would happen to its stock price?

e. What did you notice about the relationship between Elf’s dividend payout policy and its price? f. What do you think is the reason for such a relationship?

Answer 1

a.	P0 =$10, EPS = $ 2 retained earnings = 0.50 , ROE = 0.20
	k = D1/P0 + g
	D1 = 0.50 x $2 = $1
	g = b x ROE = 0.50*0.20 = 0.10
	Therefore, k = $1/$10 + .10 = 0.10+0.10 = 0.20 OR 20%
b.	If all earnings were paid as dividends its price would be:
	P0 = $2/0.2 = $10
	Thus, its price is the same whether it reinvests or not. This is because k = ROE.
c	The PVGO of the company is 10-2 = $8
d.	Since k the investor return = rate of return of the project, the stock price would not be affected by cutting the dividend and investing the additional earnings in the project
e	The stock price is not getting impact due to change in dividend payout ratio since the investor return and rate of return of the project is the same. The growth rate which is calculated from the retained ratio and the rate of return is the reason for such relationship