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 $2.80, K_e is 12 percent, and g is 5 percent.
Under Plan A, D₀ would be immediately increased to $3.40 and K_e and g will remain unchanged.
Under Plan B, D₀ will remain at $2.80 but g will go up to 6 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 $3.40 (1.05). K_e will equal 12 percent, and g will equal 5 percent. (Round your intermediate calculations and final answer to 2 decimal places.)

Stock price for Plan A

b. Compute P₀ (price of the stock today) under Plan B. Note D₁ will be equal to D₀ × (1 + g) or $2.80 (1.06). K_e will be equal to 12 percent, and g will be equal to 6 percent. (Round your intermediate calculations and final answer to 2 decimal places.)

Stock price for Plan B

c. Which plan will produce the higher value?

• Plan B

• Plan A

Answer 1

Using the dividend growth model we can calculate price of stock today
P0 = D0*(1+g)/(Ke-g)
P0 is the price today
D0 is dividend paid today
g is growth rate
Ke expected return on stock
a.
Computer P0 under plan A
P0	3.40*(1.05)/(0.12-0.05)
P0	3.57/0.07
P0	$51.00
b.
Computer P0 under plan B
P0	2.80*(1.06)/(0.12-0.06)
P0	2.968/0.06
P0	$49.47
c.
Plan A would provide higher stock price