Question

XYZ Corporation has total earnings of $500 Million which are
projected to remain constant. XYZ also has total shares outstanding of 300 million. The corporation
intends to distribute dividends to its shareholders according to the following schedule:
Period 1: Give a dividend payout rate of 40%
Period 2: Give a dividend payout rate of 100%.

Period 3 until forever: Give a dividend payout rate of 70%. Dividends are also projected to grow at a
rate of 4% every year forever.

(a) 5 Points. Find the price of XYZ corporation’s stock in period 2 (call it P2). Given P2 write
down the formula that would determine the (per share) price of XYZ’s stock today (P0). Assume
equity cost of capital is 8%. (NOTE: You have to plug in all relevant information into the formula
for full credit).

(b) 5 Points. What is the expected total return from this stock? Assume, you will sell the stock at
the end of period 2. (NOTE: To get full credit you need to write down the expression that would
calculate the total return)

(c) 5 Points. Suppose that in Period 3, XYZ also intends to start buying back some of its shares
outstanding and it intends to spend 20% of its earnings to do so. According to the total payout
model, what would be the stock price of XYZ Corporation in period 2?

(d) 5 Points. As of April 6th, 2020 one share of Microsoft’s stock traded at $165. On the other
hand, one share of stock by Berkshire Hathaway traded at $277,000. Provide one reasons that
might explain the large difference in the stock price between these corporations.

Answer 1

For Question (a)

The share price of XYZ corporation in Period 2 (P2)=

Earnings*dividend payout ratio of period 2 + [earnings*dividend payout ratio of period 3*(1.04)/ (Cost of equity - perpetual growth) + earnings*dividend payout ratio of period 3]/1.08

500*100% + [500*70%*1.04/(.08-.04) + 500*70%]/1.08

Answer= 9250/number of share = 9250/300 = 30.83

Share Price at P0 formula = P2/(1+cost of equity)^2 + earnings*dividend payout ratio/Numbert of shares/(1+cost of equity)

= 30.83/(1.08)^2 + 500*40%/300/1.08

Answer= 27.05

For Question (b)

Expected total return of the stock at P2 = P2/P0 -1

30.83/27.05-1 = 13.97%

For Question (c)

Earnings left after spending for shares buyback = 100 - 20%= 80%

The share price of XYZ corporation in Period 2 (P2) after buying back = Earnings*dividend payout ratio of period 2+ [earnings*dividend payout ratio of period 3*(1.04)*80%/ (Cost of equity - perpetual growth) + earnings*dividend payout ratio of period 3*80%]/1.08

500*100% + [500*70%*1.04*80%/(.08-.04) + 500*70%*80%]/1.08

=7500/300 = 25(Answer)

For Question (d)

The reason for such a large difference can be that Microsoft has indulged in splitting their stocks that is increasing the number of shares in the market. As a result of this the share price falls but the Market cap remains the same. Example 2:1 stock split, gives the shareholder 2 stocks for every 1 stock