Eastern Telecom is trying to decide whether to increaseitscash dividend immediat
ID: 2662661 • Letter: E
Question
Eastern Telecom is trying to decide whether to increaseitscash dividend immediately or use the funds to increase itsfuturegrowth rate. With the definition of terms below, answerthefollowing questions. P0 = D1/Ke-g P0 = price of stock today D1 = dividend at the end of the first year d1-d0*(1+g) D0 = dividend today Ke = required rate of return g = constant growth rate of dividends D0 is currently $3.00, Ke is 10 percent, and g is5percent. Under Plan A, D0 would be immediately increasedto$3.40 and Ke and g will remain unchanged. Under Plan B, D0 will remain at $3.00 but g will go up to6percent and Ke will remain unchanged. a. Compute P0 (price of stock today) under PlanA. Note D1 will be equal to D0*(1+g) or $3.40 (1.05). Ke willequal 10percent and g will equal 5 percent. b. Compute P0 (price of the stock today) under PlanB. Note D1 will be equal to D0*(1+g), or $3.00 (1.06). Ke willbe equal to 10 percent and g will be equal to 6percent. c. Which plan will produce the higher value? Eastern Telecom is trying to decide whether to increaseitscash dividend immediately or use the funds to increase itsfuturegrowth rate. With the definition of terms below, answerthefollowing questions. P0 = D1/Ke-g P0 = price of stock today D1 = dividend at the end of the first year d1-d0*(1+g) D0 = dividend today Ke = required rate of return g = constant growth rate of dividends D0 is currently $3.00, Ke is 10 percent, and g is5percent. Under Plan A, D0 would be immediately increasedto$3.40 and Ke and g will remain unchanged. Under Plan B, D0 will remain at $3.00 but g will go up to6percent and Ke will remain unchanged. a. Compute P0 (price of stock today) under PlanA. Note D1 will be equal to D0*(1+g) or $3.40 (1.05). Ke willequal 10percent and g will equal 5 percent. b. Compute P0 (price of the stock today) under PlanB. Note D1 will be equal to D0*(1+g), or $3.00 (1.06). Ke willbe equal to 10 percent and g will be equal to 6percent. c. Which plan will produce the higher value?Explanation / Answer
a) The formula for calculatingprice of stock is
P0 = D1 / (Ke – g)
Where D1 = $3.40(1.05) = $3.57
Ke = 10%
G = 5%
Substituting the given values in the above formula, we get
P0 = $3.57/ (0.05) =$71.4 {since(Ke – g) = (0.1 -0.05) = 0.05}
b) In Plan-B , D1 =$3(1.06) = $3.18
Ke = 10%
G = 6%
Substituting these values in the above formula, we get
P0 = $3.18 / (0.04) {since (Ke – g) = (0.1 -0.06) = 0.04}
= $79.5
c) Therefore after calculating theprice of stock of plan-A and plan-B, the second plan that is plan-Bis producing higher value of $79.5 compared to plan-A which is$71.4
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