The stock of Nogro Corporation is currently selling for $10 per share. Earnings

Question

The stock of Nogro Corporation is currently selling for $10 per share. Earnings per share in the coming year are expected to be $2. The company has a policy of paying out 50% of its earnings each year in dividends. The rest is retained and invested in projects that earn a 20% rate of return per year. This situation is expected to continue indefinitely.

Assuming the current market price of the stock reflects its intrinsic value as computed using the constant-growth DDM, what rate of return do Nogro’s investors require? (Do not round intermediate calculations.)

By how much does its value exceed what it would be if all earnings were paid as dividends and nothing were reinvested?

The stock of Nogro Corporation is currently selling for $10 per share. Earnings per share in the coming year are expected to be $2. The company has a policy of paying out 50% of its earnings each year in dividends. The rest is retained and invested in projects that earn a 20% rate of return per year. This situation is expected to continue indefinitely.

Explanation / Answer

a. Market Price = D/(Required return - Growth rate)
10 = 1/(RR - 20%)
Required return = 30%

b. Growth rate will be zero in this case since all earnings are distributed as dividend.
Market price = 2 / 30% = $6.67
PVGO = 10 - 6.67 = $3.33

c-1 New dividend = 2 x 25% = $0.5
Stock Price = 0.5/(0.30 - 0.20) = $5
Thus, Stock price will decrease.

c-2 In this DDM cannot be use since there is no Dividend. We need to calculate the Stock price using constant earning growth model. If we use DDM approach it will show market price as zero since dividend is zero and the answer would be Stock price will decrease. And if we use earnings approach, then the stock price will be as follows.

Stock price = 2/(0.30 - 0.20) = $20. Thus, the stock price will increase.

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