Question

Computer stocks currently provide an expected rate of return of 19%. MBI, a large computer company, will pay a year-end dividend of $5 per share.

Requirement 1:

If the stock is selling at $52 per share, what must be the market's expectation of the growth rate of MBI dividends? (Round your answer to 2 decimal places. Omit the "%" sign in your response.)

Growth rate

%

Requirement 2:

(a)	If dividend growth forecasts for MBI are revised downward to 5% per year, what will happen to the price of MBI stock?
	(Click to select)FallsRises

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

Answer 1

a) Expected return using constant dividend growth model is computed as follows -

Ke = ( D1 / P0 ) + g

where, Ke = expected return, D1 = expected dividend, P0 = stock price, g = growth rate

From the above formula, we can derive growth rate as -

g = Ke - (D1 / P0)

or, g = 0.19 - ($5 / $52) = 0.0938462 or 9.38%

b) P0 = D1 / (Ke - g)

or, P0 = $5 / (0.19 - 0.05) = $35.71429 or $35.71

Therefore, the stock price falls to $35.71.

c) P/E Ratio = market price / Earnings per share

Since market price has fallen, the numerator of the ratio has fallen, therefore, the PE ratio will decrease.