Suppose a company has a net income of $1,000,000 and a plowback ratio of 40%. Th

Question

Suppose a company has a net income of $1,000,000 and a plowback ratio of 40%. There are 50,000 shares of stock outstanding. The company plans to increase dividends by 22% each year for the next 2 years and then apply a 2.25% growth rate to dividends each year indefinitely. The required return is 13%.

A) What will this year's dividend be?

B) What should the stock price be today?

C) What is this year's dividend yield? What is this year's capital gains yield?

D) What will the stock price be in 2 years?

E) What will dividend yield and capital gains yield be in 2 years?

Explanation / Answer

A) Plowback Ratio is 40% so 60% is paid as a dividend.

So,Total dividend paid =60%*1000000

=600000

Number of shares = 50000

Dividend Paid per share =600000/50000

DPS=$12

B)

Current Dividend                             = $ 12.00

Dividend after 1st year will be     = $ 14.64 ($ 12x 1.22 – growing at 22 %)

Dividend after 2nd year will be    = $ 17.86 ($ 14.64 x 1.22 – growing at 22%)

Second stage has a growth rate of 2.25% indefinitely.

Dividend value at the end of 3rd year = 17.86*1.0225= $18.26

Now, we have to calculate present value of all future cash flows gorwing at a constant g rate of 2.25%

V(also known as terminal value)= 18.26/13%-2.25%

V=$169.86

13%

Thus Stock price today should be $159.97

C) Dividend Yield= 12/159.97 assuming market price= expected price

Dividend yield= 7.50%

For calculating this years capital gains yield intial stock price must be given in the quesion.

D) Stock price in 2 years= Next years dividend/k-g

=18.26/13%-2.25%

Stock price in 2 years=$169.86

E)Dividend yield=17.86/169.86

=10.51%

Capital Gains yield =169.86-159.97/159.97

=6.18%

Tenor Dividend Discount rate Present Value 1 14.64

13%

12.96 2 17.86 13% 13.99 2 169.86 13% 133.02 Total Present Value 159.97

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