Question

Question 3

Sports plc expects this year earnings of £6 per share and plans to pay a £2.5
dividend per share, retaining the rest to reinvest in new projects with an expected
return of 10% per year. Assuming that Sports plc will maintain the same dividend
payout rate and return on new investments in the future and will not change the
number of outstanding shares:
a) What is the earnings growth rate according to the plans of Sports plc?

b) If the equity cost of capital for Sports plc is 8% per year, what is your estimate of
its share price?

c) Suppose now that Sports plc examines an alternative plan according to which it
would instead pay a £1.5 dividend per share and it would retain the remaining
earnings for new investment projects that would yield an expected return of 12%
per year. However, this alternative payout and investment policy would increase
its riskiness, and hence its cost of equity capital would increase to 10% per year. If
Sports plc maintains this lower payout rate in the future, what is your estimate of
its share price according to this alternative plan? Would you advise the board of
directors to adopt this alternative plan? Explain your answer.

Please, type it, as it is hard to understand handwriting.

Answer 1

expected earnings per share , E1 = £6

expected divvidend per share , d1 = 2.5

expected return , R = 10% = 0.10

dividend payout ratio, r1 = d1/E1 = 2.5/6 = 0.416666666

retention ratio , b = 1- r1 = 1-0.416666666 = 0.583333333

a) earnings growth rate, g = R*b = 10*0.583333333 = 5.83333333 or 5.83%

b) equity cost of capital , r = 8% = 0.08

current stock price = d1/(r-g) = 2.5/(0.08-0.05833333) = 2.5/0.02166667 = 115.3845976 or £115.38 ( rounding off to 2 decimal places)

c)

expected earnings per share , E1 = £6

expected divvidend per share , d1 = 1.5

expected return , R = 12% = 0.12

dividend payout ratio, r1 = d1/E1 = 1.5/6 = 0.25

retention ratio , b = 1- r1 = 1-0.25 = 0.75

earnings growth rate, g = R*b = 12*0.75 = 9%

new equity cost of capital , r = 10% = 0.10

current stock price = d1/(r-g) = 1.5/(0.10-0.09) = 1.5/0.01 = 150

since the firm is able to reinvest its earnings at a higher rate of return of 12% in a lower dividend payout ratio plan , I would advise the board to adopt this alternative plan