Question

Company ABC expects to pay a dividend per share of $10 next year, which represents 100% of its earning. The expected return from investors is 10%. The company's return on equity is 12%.

a) Calculate the price of a share assuming that the company pays out 100% of its earning in dividend.

b) Calculate the price of a share if the company decides to plowback 80% of its earning into the firm's operations and investments.

c) Assuming a plowback ratio of 80%, calculate the firm's present value of growth opportunities (PVGO).

d) Explain why it may be optimal for a firm to lower its plowback ratio as it matures.

Answer 1

Price of the share=Next year dividend/(expected return-growth rate)

a. In first case, retention ratio=0 because 100% earnings are paid as dividends.

growth rate=retention ratio*Return on equity.

Therefore growth arte=0

Price of the share=10/10%=$100

b. In second case, retention rate=80%. Therefore dividend next year=(1-80%)*10=$2

growth rate=80%*12%=9.6%

Price of the share=2/(10%-9.6%)=$500

c. present value of growth opportunities (PVGO)=Value of stock – (earnings / cost of equity)

=500-(10/10%)=500-100=$400

d. As the company reaches maturity stage, there will be not be much opportunites to invest. Hence companies will lessen the retained earnings (plowback) and distribute mostly as dividends to the shareholders.