Question

Corporate Finance I

JRN Enterprises just announced that it plans to cut its dividend from $2.50 to $1.50 per share and use the extra funds to expand its operations. Prior to this announcement, JRN's dividends were expected to grow at 4% per year and JRN's stock was trading at $25.00 per share. With the new expansion, JRN's dividends are expected to grow at 8% per year indefinitely. Assuming that JRN's risk is unchanged by the expansion, what will the value of a share of JRN be after the announcement?

Answer 1

Step 1: We need to calculate value of R

Using the Dividend Discount Model
Po= Div1/ (r-g)

Dividend for next year = Div1 = $2.50
Cost of equity = r = ??
growth rate of dividends/earnings = g = 4%
Current stock price = Po= $25.00

Putting values in formula

25 = 2.5 / r - 4%

r = 4% + 2.5/25

r = 4 + 10

r = 14%

Step 2: Calculate the new share price

Div1 = $1.50
r = 14.%
g = 8%
Current stock price = Po =

Po =  Div1/ (r-g)

= 1.5 / 14% - 8%

=1.5/ 6%

= $25

Thus value of current stock is $25