Question

Dfb, Inc. expects earnings at the end of this year of $4.19 per share, and it plans to pay a $2.43 dividend at that time. Dfb will retain $1.76 per share of its earnings to reinvest in t 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 the number of outstanding shares.

a. What growth rate of earnings would you forecast for Dfb?
b. If Dfb's equity cost of capital is 12.29%, what price would you estimate for Dfb stock today?
c. Suppose Dfb instead paid a dividend of $3.43 per share at the end of this year and retained only $0.7 per share in earnings. If Dfb maintains this higher payout rate in the future, what stock price would you estimate now? Should Dfb raise its dividend?

Answer 1

The growth rate of earnings for Dfb, Inc. is calculated using the retention rate and the expected return on new investments. The price of Dfb stock is estimated using the Dividend Discount Model, considering the equity cost of capital and growth rate. A change in dividend policy affects the stock price and should be evaluated in the context of company strategy and investor preferences.

Step-by-step explanation:

To forecast the growth rate of earnings for Dfb, Inc., we use the retained earnings and the expected return on new investments. The growth rate can be calculated by multiplying the retention rate ($1.76 retained / $4.19 earnings per share) by the expected return on new investments (15.1%).

To estimate the price of Dfb stock today given an equity cost of capital of 12.29%, we use the Gordon Growth Model, which assumes a constant growth rate and dividend payments. The Dividend Discount Model is applied: P0 = D1 / (k - g) where D1 is the dividend next year (which equals this year's, because of the constant payout rate), k is the discount rate (equity cost of capital), and g is the growth rate of dividends (which is equivalent to the growth rate of earnings here).

If Dfb increased its dividend to $3.43 with a retention of $0.76, the new growth rate would be lower, but the initial dividend would be higher. By applying the Dividend Discount Model again with these new values and maintaining the same cost of capital, we would obtain a new price for the stock.

It is not clear whether Dfb should raise its dividend without considering other factors such as investment opportunities, market conditions, and shareholder preferences. A higher dividend might attract income-focused investors but could also indicate fewer growth opportunities within the company.