4) In March of 2005, Domestic Paper stock sold for $73. Security analysts were f

Question

4) In March of 2005, Domestic Paper stock sold for $73. Security analysts were forecasting a long-term earnings growth rate of 8.5%. The company was paying dividends of $1.68 per share.

A: If dividends are expected to grow along with earnings at g = 8.5% per year in perpetuity, what rate of return (rE) were investors expecting?

B: If instead Domestic Paper is expected to earn 12% on book equity (ROE) and to retain 50% of its earnings. Based on these new forecasts and the current $73 price, recalculate g and rE?

Explanation / Answer

d1= d0 * (1+g)

A.) d1 = d0 * g

d1 = 1.68 * 1.085 = 1.82

Gorden growth model Price = d1/r-g

73 = 1.82/ r - .085,

solve for r. r = 0.10993 or 10.99%

B.) sustainable growth rate

g = ROE * (1- dividend payout ratio)

= 12% * .5 = 6%

now solve for d1 and r..,

d1 = 1.68 * 1.06 = 1.78

73 = 1.78/ r - .06

r = 0.08438 or 8.44%

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