A firm’s stock earns $2 per share, and the firm distributes 40 percent of its ea

Question

A firm’s stock earns $2 per share, and the firm distributes 40 percent of its earnings as cash dividends. Its dividends grow annually at 4 percent.

a) What is the stock’s price if the required return is 8 percent?

b) The firm borrows funds and, as a result, its per-share earnings and dividends increase by 20 percent. What happens to the stock’s price if the growth rate and the required return are unaffected? What will the stock’s price be if after using financial leverage and increasing the dividend to $1, the required return rises to 10 percent? What may cause this required return to rise?

Explanation / Answer

Earning per share = $2 per share

Dividend per share = EPS * 40%

                                     = 2 * 0.4

                                     = $0.8

Current year dividend = $0.8

Next year dividend = 0.8 * (1+0.04)

                                    = 0.8 * 1.04

                                    = $0.832

Price of the stock is PV of the entire dividend which will be received by the stock.

Dividend discounting method is used to find the share present value by discounting the predicted dividend

Formula is,

Value of share = Dividend per share/ (Discount rate -Dividend growth rate)

Let's put all the values in the formula  

= 0.832/ 0.08 -0.04

= 0.832/ 0.04

= 20.8

So the price of the stock is $20.8

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