Question

Assume that discount rate (capitalization rate) is 14.5% and a company pays all of its earnings as dividends which amounts to $15 per share.

(a) Find the current stock price.
(b) What will happen to the stock price if the company managers think that there are good investment opportunities and retain 30% of the earnings (plowback ratio) when the return on equity of the stock is ROE=0.15?
(c) Why do you think the stock price increase, when the dividends paid to investors decrease?

Answer 1

The current stock price is calculated using the Dividend Discount Model, giving a value of $103.45 per share with a dividend of $15 and discount rate of 14.5%.

Step-by-step explanation:

To calculate the current stock price with a dividend payment of $15 per share and a discount rate of 14.5%, we use the Dividend Discount Model (DDM), which, under the assumption that dividends are the expected cash flows, states that the price is equal to the Dividends per Share divided by the discount rate. Thus, the price equals $15 / 0.145, resulting in $103.45 per share.

If the company managers decide to retain 30% of the earnings for investment opportunities, the plowback ratio would be 0.3, and the expected return on these retained earnings would be the ROE of 0.15. As a result, the revised dividend payout is 70% of $15, equaling $10.50. Now, assuming the firm's investments generate returns at the ROE, the future dividends are expected to increase, due to the compounding effect of the reinvested earnings.

The stock price may increase even when dividends decrease because retaining earnings for reinvestment can lead to higher future dividends and enhanced growth prospects for the company, thereby lifting its stock price through improved future earning potentials.