Question

A certain company just announced it will cut next year's dividends from $4 to $2.50 per share and use the extra funds to expand. Prior to the announcement, the company's dividends were expected to grow at a 4% rate, and its share price was $50. With the planned expansion, the company's dividends are expected to grow at a 6% rate. What share price (in dollars) would you expect after the announcement

Answer 1

P0 = $41.6666666 rounded off to $41.67

Step-by-step explanation:

The constant growth model of dividend discount model (DDM) can be used to calculate the price of the stock today. DDM calculates the price of a stock based on the present value of the expected future dividends from the stock. The formula for price today under constant growth DDM is,

P0 = D1 / (r - g)

Where,

D1 is the dividend expected in Year 1 or next year

g is the constant growth rate in dividends

r is the discount rate or required rate of return

We first need to calculate the required rate of return for this company based on the previous growth rate, dividend and current share price prior to announcement.

50 = 4 / (r - 0.04)

50 * (r - 0.04) = 4

50r - 2 = 4

50r = 4 + 2

r = 6 / 50

r = 0.12 or 12%

Now using the post announcement data, the new share price will be,

P0 = 2.5 / (0.12 - 0.06)

P0 = $41.6666666 rounded off to $41.67