Question

B Inc. has developed a new product, and the consumers are interested in it. As a result, the firm projects the growth rate of dividends is 20% per year for 4 years. By then, other firms will develop similar products, competition will drive down profit margins, and the sustainable growth rate will fall to 6%. B Inc. just paid annual dividend of $1 per share. The required return on the company’s stock is 10%.

1. What is the stock price today?

2. Suppose you buy the stock now and sell it in 1 year. What is the dividend yield? What is the capital gains yield?

3. B Inc. wants to reduce its equity without changing its operations or capital investment outlays. The financial manager of B Inc. suggests three ways to reduce equity: increase regular dividend, distribute a special dividend, or share repurchase. In either case, $10,000 cash would be spent. Which of these actions would you recommend? Why?

Answer 1

For the next 4 years, the dividends will be 1.2, 1.44, 1.728, 2.074 (based on 20% growth rate)

Now, we calculate the terminal value using the Gordon growth formula:

TV = D*(1+g)/(r-g) = 2.074 x 1.06/(0.1-0.06) = 54.961.

Now, we discount all the cash flows:

Price = 1.2/1.1 + 1.44/1.1^2 + 1.728/1.1^3 + 2.074/1.1^4 + 54.961/1.1^4

Price = 42.535

If we buy the stock now and sell in one year, we would receive a dividend of 1.2. Hence, the dividend yield will be = 1.2/42.535 = 2.82%.

The capital gains yield will be calculated by multiplying the stock price by 1.1 (1 + discount rate) and subtracting the dividend to get the final stock price.

Stock Price = 1.1 x 42.535 - 1.2 = 45.5885.

Hence, the capital gains yield is = (45.5885 - 42.535)/42.535 = 7.178%.

Increasing the regular dividend is not recommended because shareholders expect the dividend rate to increase or stay the same. Hence, increasing it once will make it difficult to reduce the rate later. A special dividend can also cause a burden on the operations of the firm. Hence, share repurchases are recommended because they reduce the overall pool of investors.