Question

Northsea Inc. is an all-equity firm and it has been paying out all its earnings as dividend. Northsea’s cost of capital is 10%, and its last Earnings Per Share is $4.50. (a) Assuming Northsea keeps paying all its earnings as dividend. What is the value of Northsea Inc. stock based on the dividend discount model? Northsea just announces that it will change it investment and dividend policy. It will continue to pay all its earnings as dividend next year but it will only distribute 70% of its earnings after next year. The retained earnings will be reinvested in projects with expected rate of return of 12%. What effect would this policy have on Northsea’s stock price (find the price)?

Answer 1

Using the dividend discount model with dividends of $4.50 per share and a cost of capital of 10%, Northsea Inc.'s stock is valued at $45. However, a change in dividend policy to retain earnings and reinvest at a 12% return rate would likely increase the value of the stock in the future.

Step-by-step explanation:

The student asks how to value Northsea Inc. stock using the dividend discount model. When a firm is expected to pay out all its earnings as dividends indefinitely, the stock value can be calculated using the formula P = D / r, where P is the stock price, D is the dividend per share, and r is the cost of capital. Since Northsea's earnings per share (EPS) is $4.50 and it pays out everything as dividend, D is $4.50. Given the cost of capital (r) of 10% or 0.10, the stock price (P) is calculated as $4.50 / 0.10, resulting in a stock price of $45.

However, once Northsea changes its dividend policy to retain 30% of earnings, the future dividends will grow as the retained earnings are reinvested at a rate of return of 12%. This change is likely to result in a higher future stock price due to the expectation of increased future dividends, driven by the reinvestment of earnings at a rate higher than the cost of capital.