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In: Finance

Suppose company A has just paid $2 in dividends and company B just paid $2.50 in...

Suppose company A has just paid $2 in dividends and company B just paid $2.50 in dividends; which company do you think will have a higher stock price? Analyze and explain how growth expectations would be factored into the analysis

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Answer

Let us assume the following few points to reach out conclusions :

The cost of capital (Ke) of both the organisation is same lets say 20%

The Payout ratio of both the organisation is same Let say 100%

As per formula :

Value of Share of Company A would be = D/Ke

= 2/0.2

= $10

Whereas,

Value of share of Company B would be = 2.5/0.2

$ 12.50

Lets further Assume few more things :

The capital base of both the organisations are same let say $10 Milion

Net Income of both the Companies is say $1 Million

Therefore both companies would have ROE of 10% Since ROE = Net Income / Capital Base

Now we need to change the payout ratio of both the companies from 100% to 50%

Then, the growth Rate for both companies would become 5% since sutainable growth rate formula is Retention Ratio * ROE

DPS (D0) of company A is $2 and that of B is $ 2.5

Now as per constant Growth Model share Price would be P1 = D1/ (Ke - g)

Where D1 is D0*Growth and P1 is the share pirce

Incorporating inputs in above formula we get :

Share Price of Company A = 2*1.05/0.2-0.05 = $14

Share Price of Company B = 2.5*1.05/0.2-0.05 = $ 17.50

Hence it can be said that company B will have higher share price than Company A, if other details and factors remains the same.

jeff jeffy answered 1 year ago
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