The stock of Nogro Corporation is currently selling for $40 per share. Earnings

Question

The stock of Nogro Corporation is currently selling for $40 per share. Earnings per share in the coming year are expected to be $6. The company has a policy of paying out 40% of its earnings each year in dividends. The rest is retained and invested in projects that earn a 15% rate of return per year. This situation is expected to continue indefinitely.

a. 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.)

Rate of return             %

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

PVGO            $  

Explanation / Answer

a.

D1 = $6 * 0.4

= $2.4

g = 0.4 * 0.15

= 0.06

Rate of return = ( $2.4 / $40 ) + 0.06

= 0.12 or 12%.

b.

PVGO = $40 + ($6 / 0.12)

= $40 - $50

= - $10.

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