3) In the past, Sunnyfax Publishing paid out all its dividends as earnings. When

Question

3) In the past, Sunnyfax Publishing paid out all its dividends as earnings. When the stock market opened for trading today, Sunnyfax's share price was $38 and earnings for the year ending today are $3 per share. At the end of the day, and after paying their $3 dividend, Sunnyfax surprises investors by announcing they will cut its dividend payout in future years from 100% to 66.67% and reinvest the retained funds. The rate of return on invested capital is expected to be 12%. If the reinvestment does not affect Sunnyfax's equity cost of capital, what is the expected share price as a consequence of this decision? A) $26.34 B) $51.35 C) $53.40 D) $80.11

I would greatly appreciate if you would post the steps involved to arrive at the correct answer. I will not rate if no steps are included. Sorry, but I'm trying to learn here.

Explanation / Answer

first find out cost of equity using equity capitalisation method:

= earnings per share/current market price =3/38 =0.07=7%

using walters model we can find share price

share price= (d/k ) + {[(e-d) x r]/k}/k

where d=dividend per share

k= cost of equity

e-d= retained earnings

r= return on investment

2/0.07+{[3-2] x 0.12}/0.07]/0.07

=53.06(approximately)

so answer is b

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