Question

RFK Limited expects earnings this year of $ 4.16 per​ share, and it plans to pay a $ 2.59 dividend to shareholders. RFK will retain $ 1.57 per share of its earnings to reinvest in new projects which have an expected return of 15.8 % per year. Suppose RFK will maintain the same dividend payout​ rate, retention rate and return on new investments in the future and will not change its number of outstanding shares.

a. ​RFK's growth rate of earnings is nothing​%. ​(Round to one decimal​ place.)

b. If​ RFK's equity cost of capital is 11.7 %​, then​ RFK's share price will be ​$ nothing. ​(Round to the nearest​ cent.)

c. If RFK paid a dividend of $ 3.59 per share this year and retained only $ 0.57 per share in​ earnings, then​ RFK's share price would be ​$ nothing. ​ (Round to the nearest​ cent.) Should RFK follow this new​ policy? ​(Select the best choice​ below.)

A. ​Yes, RFK should raise dividends​ because, according to the​ dividend-discount model, doing so will always improve the share price.

B. ​No, RFK should not raise dividends because companies should always reinvest as much as possible.

C. ​No, RFK should not raise dividends because the projects are positive NPV.

D. ​Yes, RFK should raise dividends because the return on new investments is lower than the cost of capital.

Answer 1

(a) Current Earnings = E0 = $ 4.16, Dividend = D0 = $ 2.59 and Retention = R0 = $ 1.57

Dividend Payout Ratio = (2.59 / 4.16) = 0.6226 and Retention Ratio = RR = (1.57/4.16) = 0.3774

Expected Return on New Investment = r = 15.8 %

Expected Growth Rate = g = r x RR = 15.8 x 0.3774 = 5.9629 %

(b) Equity Cost of Capital = R = 11.7 %

Expected Dividend = D0 x (1+g) = 2.59 x 1.059629 = $ 2.7444

Current Stock Price = D1 / (R - g) = 2.7444 / (0.117 - 0.059629) = $ 47.836 ~ $ 47.84

(c) New Dividend = D0 = $ 3.59 and New Retention = R0 = $ 0.57

Dividend Payout Ratio = 3.59 / 4.16 = 0.86298 and Retention Ratio = 0.57 / 4.16 = 0.13702

New Growth Rate = 0.13702 x 15.8 = 2.1649 %

Expected Dividend = D1 = D0 x (1+g) = 3.59 x 1.021649 = $ 3.6677

Current Stock Price = D1 / (R - g) = 3.6677 / (0.117 - 0.021649) = $ 38.465 ~ $ 38.46

(d) The firm should not increase dividends becuse the projects have a positive NPV and generate returns (15.8%) greater than the cost of capital (11.7%), thereby being value accretive to the firm. The same decision can be arrived at by comparing answers of part (b) and part(c). Since, share price is greater in absence of increased dividends, the same policy should be followed (dividends should not be increased).