Question

BOON Mining just announced it will cut its dividend from $3.84 to $2.65 per share and use the extra funds to expand. Prior to the announcement, BOONs dividends were expected to grow at a 3.2% rate, and its share price was $49.36. With the planned expansion, BOON's dividends are expected to grow at a 4.8% rate. What share price would you expect after the announcement? (Assume that the new expansion does not change BOON's risk.) Is the expansion a good investment?

The new price for BOON's stock will be?

Answer 1

Before announcement,

Rate of return (r )= D₀*(1+g)/P₀ + g

Where

D₀= Current dividend (given as $3.84), g= growth rate of dividend (3.2%) and P₀= Price ($49.36)

Plugging the inputs,

Rate of return (r )= 3.84*(1+0.032)/49.36 + 0.032 = 11.228525%

After announcement:

Price= D₁/(r-g)

Where

D₁= next year dividend (given as $2.65)

Growth rate (g) will be 4.8%

Since the risk perception does not change, rate of return will continue at 11.228525%

Plugging the inputs,

New price= 2.65/(0.118525-0.048) = $41.22

Even though the growth rate is expected to increase from 3.2% to 4.8%, that is not commensurate with the investment made by reducing dividend payout. This is evidenced by the reduction price from $49.36 to $41.22. Hence the expansion is not a good investment.