Question

The Ship-Quick Logistics Company is trying to decide whether to cut its expected dividends for next year from $10 per share to $6 per share in order to have more money to invest in new projects. If it does not cut the dividend, the firm’s expected rate of growth in dividends is 4 percent per year and the price of their common stock will be $150 per share. However, if it cuts its dividend, the dividend growth rate is expected to rise to 5 percent in the future. Assuming that the investor's required rate of return for the stock does not change, what would you expect to happen to the price of its common stock if it cuts the dividend to $6? Should Ship-Quick cut its dividend?

$99.99 ; Should not cut its dividend

$105.82; Should not cut its dividend.

$110.55 ; Should cut its dividend.

$155.32 ; Should cut its dividend.

$175.65 ; Should not cut its dividend.

Answer 1

Using Dividend Discount Model (DDM), Price of a stock can be calculated using the formula: D1/(r-g); where D1 is dividend paid next year, r is required rate of return and g is constant growth rate of dividend.

If the dividend is unchanged at $10, we have,

150= 10/(r-4%)

r= (10/150)+4%= 10.67%

If the dividend is changed to $6, we have,

P= 6/(10.67%-5%)= $105.82.

As the price of the stock decreased from $150 to $105.82, Ship-Quick should not cut its dividend.

$105.82; Should not cut its dividend. (Option b).