Question

As a financial analyst, you are considering a potential investment in a company that appears to be of great value.                                                                   

Required:

a. The company is expected to earn $28 per share at the end of this year. If the fair rate of return for this stock is 10 percent, what is an appropriate price per share for the stock if the company pays out all earnings as dividends?

b. If the company were to pay out half of its earnings as dividends and re-invest the remainder in the company to earn 12 percent, how would the value per share change?

c. Interpret the difference between your answers to parts a. and b

Answer 1

C) Difference is price is due to the higher rate of return on the retained earnings when compared to that of the expected rate of return of investor.

In given case expected rate of return is 10% so when all the earnings are distributed there will no growth as no earnings are available for investment.

However when 50% of the earnings are retained ot will add to additional growth of the company which will inturn result in increased returns to the investors.