Omni Telecom is trying to decide whether to increase its cash dividend immediately or use the funds to increase its future growth rate.
|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 $3.20, Ke is 11 percent, and g is 6 percent.
Under Plan A, D0 would be immediately increased to $3.60 and Ke and g will remain unchanged.
Under Plan B, D0 will remain at $3.20 but g will go up to 7 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 $3.60 (1.06). Ke 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). Ke 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?
a) Price of the stock today under Plan A:
ke = 11%
P0 = 3.816/11%-6%
b) Price of stock today under Plan B:
ke = 11%
P0 = D1/ke-g
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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