Question

DFB, Inc., expects earnings at the end of this year of $4.62 per share, and it plans to pay a $2.78 dividend at that time. DFB will retain $1.84 per share of its earnings to reinvest in new projects with an expected return of 15.1% per year. Suppose DFB 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. What growth rate of earnings would you forecast for DFB?
b. If DFB's equity cost of capital is 11.1%, what price would you estimate for DFB stock today?
c. Suppose DFB instead paid a dividend of $3.78 per share at the end of this year and retained only $0.84 per share in earnings. That is, it chose to pay a higher dividend instead of reinvesting in as many new projects. If DFB maintains this higher payout rate in the future, what stock price would you estimate now? Should DFB raise its dividend?

Answer 1

We calculate the forecasted growth rate of earnings for DFB, Inc. using the expected return on reinvested earnings, estimate the stock price with the equity cost of capital using the Gordon Growth model, and examine the effects of a higher dividend payout on the stock price.

Step-by-step explanation:

The question involves calculating the forecasted growth rate of earnings, estimating the stock price using the dividend discount model (DDM), and evaluating the effect of altering the dividend payout on the stock price. This requires an understanding of finance fundamentals such as earnings retention, return on investment, payout ratios, and present value calculations.

Growth Rate of Earnings Forecast

The retained earnings component that is reinvested at a return of 15.1% will fuel the growth of DFB, Inc. The growth rate of earnings can be forecasted by the rate of return on these new investments, which is 15.1%.

Estimated Stock Price with Equity Cost of Capital

With an equity cost of capital at 11.1%, the stock price is calculated using the Gordon Growth model as follows: P = D / (r - g), where P is price, D is the next year's dividend, r is the equity cost of capital, and g is the growth rate. The estimated stock price would be $2.78 / (0.111 - 0.151) which is problematic as the growth rate exceeds the required return, suggesting a reevaluation of inputs or model is necessary.

Effect of Higher Dividend Payout

Increasing the dividend to $3.78 and retaining $0.84 would reduce the growth rate of earnings, potentially altering investor expectations and the stock price model. An investor needs to consider the trade-off between higher dividends now and lower growth rates in the future, which influences the estimated stock price.