Question

1. Electric Car expects to have earnings per share of $5 in 2020. The firm plans to pay all of its earnings as dividends. Electric Car’s current share price is $50.

A. Suppose Electric Car continues earning $5 per share annually in 2021-2026 and could cut its dividends payout rate to 75% during this period. Electric Car is planning to apply the retained earnings to open new stores. The return on investment in these stores is expected to be 12%. Assume that the risk of the new investments is the same as the risk of existing investments. What effect would this new dividend payout policy have on Electric Car’s share price in 2020?

B. Suppose Electric Car decided to cut its dividend payout rate to 75% to invest in new stores, yet now suppose that the return on these new investments is 8%, rather than 12%. Given its expected earnings per share this year of $5 and same cost of capital (return) as in A., what will happen to Electric Car’s share price in 2020?

Answer 1

In the given question, the following information is given:

EPS = $5

DPS = $5 (since all the earnings are distributed as dividend)

Current share price (P0) = $50

Part I: First of all, we calculate the cost of equity (Ke) with the following formula:

P0 = DPS/Ke

therefore, Ke = DPS/P0 = 5/50 = 10%

Part II  Calculation of share price under options (A) and (B)

Option A  

Given: EPS = $5

Dividend payout ratio (D/P ratio) = 75% (D/P ratio = DPS/EPS, hence, DPS in this case = EPS*D/P ratio, i.e. 5*75% = $3.75)

Retention ratio = 25%

Return on retained earnings (r) = 12%

Risk of new investment (i.e. Ke) = 10% (as calculated in Part I)

With the given information, P0 can be calculated using walter's dividend model, which is as follows:

P0 = DPS + r/Ke (EPS - DPS)

Ke

Using the given information in this formula, we get

P0 = 3.75 + 0.12/0.10 (5-3.75)

0.10

P0 = 5.25/0.10

P0 = $ 52.50

Option B

Given that DPS = $ 3.75 (as calculated in option A using D/P ratio)

r = 8%

Ke = 10 %

Accordingly, P0 = DPS + r/Ke (EPS - DPS)

Ke

Therefore,

P0 = 3.75 + 0.08/0.10 (5-3.75)

0.10

P0 = 4.75/0.10

P0 = $ 47.50

The above solutions are summarised hereunder:

Current share price under Option A: $ 52.50

Current share price under Option B: $ 47.50

Trust the above solution helps.

Thanks