Question

The dividend-growth model, suggests that an increase in the dividend growth rate will increase the value of a stock. However, an increase in the growth may require an increase in retained earnings and a reduction in the current dividend. Thus, management may be faced with a dilemma: current dividends versus future growth. As of now, investors’ required return is 10 percent. The current dividend is $0.9 a share and is expected to grow annually by 5 percent, so the current market price of the stock is $18.9. Management may make an investment that will increase the firm’s growth rate to 9 percent, but the investment will require an increase in retained earnings, so the firm’s dividend must be cut to $0.7 a share. Should management make the investment and reduce the dividend? Round your answer to the nearest cent.

The value of the stock -Select- to $ , so the management -Select- make the investment and decrease the dividend.

Answer 1

FORMULA -  Stock Price = Current Dividend * ( 1 +Growth rate ) / ( Required rate of Return - Growth rate)

Stock Price = 0.7* (1+ 0.05) / (0.10 - 0.05)
= 0.7 *(1.05) / (0.05)

=0.7 *21

= 1.47

The value of the stock rises to $14.7, so the management should make the investment and decrease the dividend.