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
K_e = Required rate of return
g = Constant growth rate in dividends

D₀ is currently $3.20, K_e is 11 percent, and g is 6 percent.
Under Plan A, D₀ would be immediately increased to $3.60 and K_e and g will remain unchanged.
Under Plan B, D₀ will remain at $3.20 but g will go up to 7 percent and K_e will remain unchanged.

a. Compute P₀ (price of the stock today) under Plan A. Note D₁ will be equal to D₀ × (1 + g) or $3.60 (1.06). K_e will equal 11 percent, and g will equal 6 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 $3.20 (1.07). K_e will be equal to 11 percent, and g will be equal to 7 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) Price of the stock today under Plan A:

P0= D1/ke-g

Given,

D0=3.6

g= 6%

ke = 11%

D1= D0*(1+g)

=3.6*(1+0.06)

=3.816

P0 = 3.816/11%-6%

= 3.816/5%

= 76.32

b) Price of stock today under Plan B:

Given

D0 =3.2

ke = 11%

g= 7%

D1= D0*(1+g)

= 3.2*1.07

= 3.424

P0 = D1/ke-g

= 3.424/11%-7%

= 3.424/4%

= 85.6

c) Price under plan A = 76.32

Price under plan B = 85.6

Since the price of stock under plan B is higher it generates higher value to the company. So Plan B should be selected.