Question

DairyBev, Inc. operates in a mature industry as a “cash cow” and thus pays out all of its earnings as dividends. But it has recently developed a new packing technology that could provide good growth potential, allowing the firm to earn a 9% return on retained earnings in future years, that is, it will generate a 9% return on its whole business going forward (not just the reinvested earnings). The new technology, however, will require ongoing investment. To obtain investment cash, DairyBev is considering reducing its dividend payout ratio immediately from 100% to 35% (in other words, increasing its earnings retentionrate from 0% to 65%). Current (t=0) earnings and dividends are $315,000. Investors are expecting—and currently earning—a return of 12% overall return. In light of this, what is the DairyBev NPVGO? (Hint: Find the value of DairyBev “as is” and then calculate its changed value with the lower dividend payout / higher growth trajectory.)

A. $540,067

B. 104,230

C. -$474,598

D. -581,484

E. -727,445

Answer 1

1. Current Value of Dairy Bev = Current Dividends / required rate = 315000 / 12% = $2625000

2. New Dividends = Current Dividend * 35% = 315000 * 35% = $110250

3. Growth rate = Retention rate * ROE = 65% * 9% = 5.85%

4. Changed value of Dairy Bev = New Dividend * (1 + Growth) / (Required rate - Growth rate)

Changed value of Dairy Bev = 110250 * (1 + 5.85%) / (12% - 5.85%)

Changed value of Dairy Bev = $1897555

5. Change in NPVGO = Changed value - Current value

Change in NPVGO = 1897555 - 2625000

Change in NPVGO = -727445 Option E

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