According to constant growth dividend discount model, we compute the intrinsic v

Question

According to constant growth dividend discount model, we compute the intrinsic value of stock at time 0 (today%u2019s computed stock price), P0=D1/(k-g), where D1 is the expected dividend next year, and k is the required return or discount rate. Assuming the required return is 20% per year.

a.       If we assume dividend will grow at a constant rate of 8% infinitely. The stock price is $35 per share. If we assume the stock is correctly priced, i.e., the stock has intrinsic value equal to its market price, what is the dividend the firm is paying to its shareholders this year?

b.      Instead of assuming that the firm will have a constant dividend growth ratio of 8%, if we assume that the firm will have ROE (return on asset) of 15% per year, expected EPS (earns per share, E1) of $2.50, and the dividend payout ratio of 60%.   Will you buy or sell the stock?

c.       The firm just makes an announcement that it expects its future ROE will be altered.   Immediately after the announcement, the stock price surges 20%. Will the expected ROE greater or smaller than 15%?  Why?

Please show your work. Question "C" is most important to me.

Explanation / Answer

a) Dividend growth model = D0(1 + Growth rate)/(Required Rate - Growth Rate)

Dividend(1.08)/(.2 - .08) = 35

Dividend = $3.89

b) They have a low ROE, probably because they pay out a lot in dividends (60%). I think you would sell the stock.

c) If the stock price goes up 20% after the announcement, people expect the ROE to be greater in the future. ROE = net income / total equity, so in order to the ROE to be greater than what it currently is (15%) the net income is going to need to increase by a greater number than the equity increased in the surge. Total equity will be larger with the 20% surge, so I think that ROE will be smaller than 15%...

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.