Question

Crane Sporting Goods expect to have earnings per share of $6 in the coming year. Rather than reinvest these earnings and grow, the firm plans to pay out all of its earnings as a dividend. With the expectation of zero growth in dividend, the firm's current share price is $60. Suppose the firm plans to cut its dividend payout rate to 75% for the forseeable future and use the retained earnings to open new stores. The return on equity for these new stores is expected to be 12%. How would this change in dividend policy affect stock prices according to discount dividend model?

		Stock price will increase
		Stock price will decrease
		Stock price will stay the same
		Not sure about the direction of change

Answer 1

EPS - $6

Current Share Price - $60

Dividend payout Ratio = 75%

ROE - 12%

Retention Ratio = 1 - DPR = 1 - 75% = 25%

Growth rate = retention ratio x return on equity = 25% x 12% = 3%

Calculation of stock price before change in Dividend policy according to dividend discount model

Stock price = Dividend/ke = $6/.12 = $50

Calculation of stock price After change in Dividend policy according to dividend discount model

New Dividend = 6 x 75% = $4.5

Stock price = Dividend(1+growth rate)/ke - growth rate = $4.5(1.03)/12%-3% = 4.635/ 9 = $51.5

Stock price Earlier is $ 50

and now is $ 51.5, hence increase in Stock price by $1.5

Note : cost of equity is not given in question therefore assuming it as equal to return on equity i.e, 12%