Question

a. Computer stocks currently provide an expected rate of return of 16%. MBI, a large computer company, will pay a year-end dividend of $4 per share. If the stock is selling at $50 per share, what must be the market's expectation of the growth rate of MBI dividends? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Growth rate            %

b-1. If dividend growth forecasts for MBI are revised downward to 6% per year, what will be the price of the MBI stock? (Round your answer to 2 decimal places.)

Price            $

b-2. What (qualitatively) will happen to the company's price–earnings ratio?

A.	The P/E ratio will decrease.
B.	The P/E ratio will increase.

Answer 1

Answer of Part a:

P0 = D1 / (k-g)
$50 = $4 / (0.16 –g)
0.16 – g = $4 / $50
0.16 – g = 0.08
g = 0.16 -0.08
g = 0.08 or 8%

Answer of Part b:

P0 = D1 / (k-g)
P0 = $4 / (0.16 – 0.06)
P0 = $4 / 0.1
P0 = $40

Answer of Part c: The correct answer is A.

The price falls in response to the more forecast of dividend growth. The forecast for current earnings however is unchanged. Therefore, the P/E ratio decreases. The lower P/E ratio is evidence of the diminished optimism concerning the firm’s growth prospects.