Question

Omni Telecom is trying to decide whether to increase its cash dividend immediately or use the funds to increase its future growth rate.

P0 = D1 Ke − g

P0 = Price of the stock today

D1 = Dividend at the end of the first year

D1 = D0 × (1 + g)

D0 = Dividend today

Ke = Required rate of return

g = Constant growth rate in dividends

D0 is currently $2.90, Ke is 9 percent, and g is 5 percent. Under Plan A, D0 would be immediately increased to $3.20 and Ke and g will remain unchanged. Under Plan B, D0 will remain at $2.90 but g will go up to 6 percent and Ke will remain unchanged.

a. Compute P0 (price of the stock today) under Plan A. Note D1 will be equal to D0 × (1 + g) or $3.20 (1.05). Ke will equal 9 percent, and g will equal 5 percent. (Round your intermediate calculations and final answer to 2 decimal places.)

b. Compute P0 (price of the stock today) under Plan B. Note D1 will be equal to D0 × (1 + g) or $2.90 (1.06). Ke will be equal to 9 percent, and g will be equal to 6 percent. (Round your intermediate calculations and final answer to 2 decimal places.)

c. Which plan will produce the higher value? Plan A Plan B

Answer 1

A)P0 = 3.2(1+.05)/( .09 -.05)

            = 3.2 *1.05 /.04

            = $ 3.36/.04

           = $ 84 per share

B)P0 = 2.9(1+.06)/(.09-.06)

          = 2.9 *1.06 / .03

          = $ 102.47 per share

C)Plan B yields higher value.