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 $2.00, K_e is 10 percent, and g is 4 percent.
Under Plan A, D₀ would be immediately increased to $2.50 and K_e and g will remain unchanged.
Under Plan B, D₀ will remain at $2.00 but g will go up to 5 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 $2.50 (1.04). K_e will equal 10 percent, and g will equal 4 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 $2.00 (1.05). K_e will be equal to 10 percent, and g will be equal to 5 percent. (Round your intermediate calculations and final answer to 2 decimal places.)

c. Which plan will produce the higher value?

• Plan B

• Plan A

Answer 1

a. P0 is computed as shown below:

= [ D0 x (1 + growth rate) ] / (required rate of return - growth rate)

= ($ 2.50 x 1.04) / (0.10 - 0.04)

= $ 43.33 Approximately

b. P0 is computed as shown below:

= [ D0 x (1 + growth rate) ] / (required rate of return - growth rate)

= ($ 2 x 1.05) / (0.10 - 0.05)

= $ 42 Approximately

c. As can be seen, Plan A will produce the higher value

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