Omni Telecom is trying to decide whether to increase its cash dividend immediately or use the funds to increase its future growth rate.
P_{0} | = |
D_{1} |
K_{e} − g |
P_{0} = Price of the stock today
D_{1} = Dividend at the end of the first
year
D_{1} = D_{0} × (1 +
g)
D_{0} = Dividend today
K_{e} = Required rate of return
g = Constant growth rate in dividends
D_{0} is currently $3.20, K_{e}
is 11 percent, and g is 6 percent.
Under Plan A, D_{0} would be immediately
increased to $3.60 and K_{e} and g will
remain unchanged.
Under Plan B, D_{0} will remain at $3.20 but
g will go up to 7 percent and K_{e} will
remain unchanged.
a. Compute P_{0} (price of the stock today) under Plan A. Note D_{1} will be equal to D_{0} × (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 P_{0} (price of the stock today) under Plan B. Note D_{1} will be equal to D_{0} × (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
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.
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