Question

Current (year 0) price of the shares of Company ABC is $50. There are 1 million shares outstanding. Next year (year 1)’s dividend per share is $2, which represents a 60% payout from earnings (net income). Investors expect a ROE of 20%, and a constant growth.

(Please solve e, f, g. Ignore a - d) (Please show your work)

a. What will be the dividend per share in year 2 and year 3?

b. What is the current market value of the firm?

c. What will be the value of the firm next year after the payout?

Suppose that the company announces that it will increase its dividend from $2 per share to $4 per share next year (year 1), and that the extra cash needed will be financed by issuing new shares. However, total dividends after next year follow the old schedule.

d. What will be the price of the new shares that the firm issue in year 1? How many new shares will beissued?

e. How much dividend will the old shareholders get in year 2?

f. Calculate the old shareholder’s present value (today) of discounted future dividends, under the new policy. What should be the current stock price under the new policy?

g. Comment on the important assumptions made in this calculation. How would your answer to f) change if the assumptions are changed?

Answer 1