Question

High-tech company expects to earn $65 per share at the end of the year and intends to pay out $35 in dividends to shareholders. The company’s net income is 500 million and its common share equity is $2,000 million

A)   Compute the future growth rate.

B)   If the investors’ required rate of return for High-tech’s stock is 18 percent, estimate the company’s common stock value.

C)   High-tech’s finance director is considering a change in the dividend policy and continue with the same dividend payout ratio permanently. Before communicating the adequate revision in the dividend policy to the shareholders, he simulated two alternatives:

• The first one is with a dividend equal $40.
• The Second one is with a dividend equal to $30

Estimate what would happen to the stock value in both cases. Explain the relationship between dividend, growth rate, and value of the stock. What do you recommend to the finance director?

D)   If the actual High-tech stock price is 600 for which dividend level, you buy the stock.

Answer 1

A)The future growth rate= Return on equity*Retention ratio

ie.(Net income/Total equity)*(1-Dividend Payout ratio)

Dividend pay-out ratio= ExpectedDPS/Expected EPS= 35/65=53.85%

ie.(500/2000)*(1-(35/65))=

ie. 25%*46.15%=

11.54%

B) If the investors’ required rate of return for High-tech’s stock is 18 percent, estimate of the company’s common stock value =

Using the dividend discount model for constant growth of dividends,

P0=D1/(r-g)

where,

P0 =the stock price to be found out----??

D1= the next dividend from now, given as $ 35

r= the investor's required return , given as 18%

g= the growth rate found out in A above-- 11.54%

Now, plugging in the values in the formula,

P0=35/(18%-11.54%)

541.80

C-1.The first one is with a dividend equal $40.

Then the DPO becomes 40/65= 61.54%

Retention ratio becomes 1-(40/65)= 38.46%

Growth rate gets revised to

ROE*RR=

25%*38.46%=

9.62%

The stock price is now

P0=D1/(r-g)

ie.40/(18%-9.62%)=

477.33

C-2. The Second one is with a dividend equal to $30

Now, the DPO becomes 30/65= 46.15%

Retention ratio becomes 1-(40/65)=53.85%

Growth rate gets revised to

ROE*RR=

25%*53.85%=

13.46%

The stock price is now

P0=D1/(r-g)

ie.30/(18%-13.46%)=

660.79

When the dividend increases, retention decreases, so growth rate decreases.

so, for the same ROE & required return for equity--- the stock price decreases--- as the increased dividends are discounted at higher rates.

Whereas,

When the dividend decreases, retention increases, so growth rate also increase.

so, for the same ROE & required return for equity--- the stock price increases--- as now the decreased dividends are discounted at much lower rates.

Summary
Dividend	g	stock price
35	11.54%	541.8
40	9.62%	477.33
30	13.46%	660.79

Giving as dividends instills confidence , in the minds of the investors.

But retaining earnings helps the company to grow.

The lesser the dividends, the more the growth rate g & the stock price

The more the dividends, the less the growth rate g & the stock price

so, the finance director has to decide which one is warranted at the moment , feel the pulse of the situation & act accordingly.

It has to be a mid decision-- to take care of investors' interests as also to influence the stock price positively, to attract potential investors.

D.Price at the dividend level of $ 35	541.80
Price at the dividend level of $ 30	660.79
As the price is given as $ 600
dividend level must be between $ 30 & $ 35