Question

​DFB, Inc., expects earnings this year of $ 4.21 per​ share, and it plans to pay a $ 1.88 dividend to shareholders. DFB will retain $ 2.33 per share of its earnings to reinvest in new projects with an expected return of 15.1 % per year. Suppose DFB will maintain the same dividend payout​ rate, retention​ rate, and return on new investments in the future and will not change its number of outstanding shares.

a. What growth rate of earnings would you forecast for​ DFB?

Earnings growth rate will be..............​%.(Round to two decimal​ places.)

b. If​ DFB's equity cost of capital is 12.4%​, what price would you estimate for DFB​ stock?

The stock price will be ​$.................​ (Round to the nearest​ cent.)

c. Suppose DFB instead paid a dividend of $2.88 per share this year and retained only $1.33 per share in earnings. That​ is, it chose to pay a higher dividend instead of reinvesting in as many new projects. If DFB maintains this higher payout rate in the​ future, what stock price would you estimate​ now?

In this case the stock price will be $.............(Round to the nearest​ cent.)

Should DFB follow this new​ policy?

This is what the company should​ do: ​ (Select the best choice​ below.)

A.Not raise dividends because companies should always reinvest as much as possible.

B.Not raise dividends because projects have positive NPV when the return on new investments is higher than the​ firm's cost of capital.

C.Raise dividends​ because, according to the​ dividend-discount model, doing so will always improve the share price.

D.Raise dividends because the return on new investments is lower than the cost of capital.

Answer 1

Answer a.

Retention Ratio = Earnings Retained / Earnings
Retention Ratio = $2.33 / $4.21
Retention Ratio = 0.55344

Growth Rate = Retention Ratio * Return on Equity
Growth Rate = 0.55344 * 15.10%
Growth Rate = 8.36%

Earnings growth rate will be 8.36%

Answer b.

Current Price = Expected Dividend / (Cost of Capital - Growth Rate)
Current Price = $1.88 / (0.1240 - 0.0836)
Current Price = $1.88 / 0.0404
Current Price = $46.53

The stock price will be $46.53

Answer c.

Retention Ratio = Earnings Retained / Earnings
Retention Ratio = $1.33 / $4.21
Retention Ratio = 0.31591

Growth Rate = Retention Ratio * Return on Equity
Growth Rate = 0.31591 * 15.10%
Growth Rate = 4.77%

Current Price = Expected Dividend / (Cost of Capital - Growth Rate)
Current Price = $2.88 / (0.1240 - 0.0477)
Current Price = $2.88 / 0.0763
Current Price = $37.75

In this case the stock price will be $37.75

Not raise dividends because projects have positive NPV when the return on new investments is higher than the​ firm's cost of capital.