Question

Crane Sporting Goods expects to have earnings per share of $6 in the coming year. Rather than reinvest these earnings and grow, the firm plans to pay out all of its earnings as a dividend. With these expectations of no growth, Crane's current share price is $60 and the cost of equity capital is 10%. Suppose Crane could cut its divident payout rate to 75% for the foreseeable future and use the retained earnings to open new stores. The return on investment in these stores is expected to be 12%. if we assume that the risk of these new investments is the same as the risk of its existing investments, then the firm's equity cost of capital is unchanged. What effect would this new policy have on Crane's stock price

Answer 1

Stock price increases

Step-by-step explanation:

We need to determine the stock price with the new policy

Stock price can be determined using the constant growth dividend model

according to the constant dividend growth model

price = d1 / (r - g)

d1 = next dividend to be paid

r = cost of equity

g = growth rate

growth rate = retention rate x Return on investment

Retention rate = 1 - payout ratio = 1 - 0.75 = 0.25

growth rate = 0.25 x 12 = 3%

Stock price = 6/(0.10 - 0.03) = $85.71

Under the new policy, stock price increases