. Below are the data for two stocks, both of which have a discount rate of 10 pe
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Question
. Below are the data for two stocks, both of which have a discount rate of 10 percent:
Stock A Stock B
Return on equity 11% 12%
Earnings per share $2.20 $.90
Dividends per share $ .95 $.50
a. What are the dividend payout ratios for each firm?
b. What are the expected dividend growth rates for each firm?
c. What is the estimated stock price for each firm?
d. Which stock has the higher market value of equity?
Explanation / Answer
Dividend payout ratio (DPR) = Dividend per share/ earnings per share
Hence dividend payout ratio for:
Stock A:
DPR = $0.95/$2.20 = 0.4318
Stock B:
DPR = $0.5/$0.9 = 0.5555
b. The expected dividend growth rate is calculated using the following formula:
Dividend Growth Rate = (Retention Ratio)*(Return on Equity)
The Retention Ratio is simple one minus the dividend payout ratio. So the retention ratio is 56.82% for stock A and 44.45% for stock B.
Therefore, their growth rates will be:
Dividend Growth for stock A = 0.5682*0.11 = 0.0625 (annual 6.25%)
Dividend Growth for stock B = 0.4445*0.12 = 0.05334 (annual 5.33%)
c. Here we use the constant dividend growth pricing model. The formula is:
Price = (Next Dividend) / (Discount Rate - Growth Rate).
Let’s assume that this dividend was paid yesterday for both firms. Thus the next dividend for stock A will be $0.95*1.0625= , and for stock B it will be $0.5*1.0533.
Therefore, using the given formula and bearing in mind that the
discount rate is 15% for both firms, we get:
Price(Stock A) = 1.009375/(0.10 - 0.0625) = $1.009375/0.0375 = $26.916667
Price(Stock B) = 0.52665/(0.10 - 0.05334) = $0.52665/0.04666 = $11.28697
d. Stock A has higher market value of equity.
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