Question

Company just announced it will cut its dividend from $3 to $1.50 per share and use the extra funds to expand. Prior to the announcement, Bill’s Bootstrap dividends were expected to grow at a 3% rate, and its share price was $20. With the new expansion, the dividend payout rate will be 40% and the return on the expansion will be 20%. What share price would you expect after the announcement and would you recommend the expansion go ahead?

Answer 1

> Formula

• Required return = Expected Dividend / Current Price + Growth rate
• Price = Expected Dividend / [ Required return - Growth rate]
• Growth rate = Return on equity * retention ratio
• Retention ratio = 1 - Dividend Payout ratio

> Calculation

Required Return = [ 3 ] / 20 + 0.03

                        = 18 %

New growth rate = 20% * ( 1-0.4)

                        = 12%

Assuming required return remains the same after expansion

New price = [ 1.5 ] / [ 0.18 - 0.12 ]

               = 25

Yes I recommend the expansion because share price plunges high after expansion.

Hope you understand the solution.