Question

The constant growth valuation formula has dividends in the numerator. Dividends are divided by the difference between the required return and dividend growth rate as follows:

Pˆ0P̂0

=  =

D1(rs – g)D1(rs – g)

Which of the following statements is true?

a- Increasing dividends will always decrease the stock price, because the firm is depleting internal funding resources.

b- Increasing dividends may not always increase the stock price, because less earnings may be invested back into the firm and that impedes growth.

c- Increasing dividends will always increase the stock price.

Walter Utilities is a dividend-paying company and is expected to pay an annual dividend of $2.25 at the end of the year. Its dividend is expected to grow at a constant rate of 6.00% per year. If Walter’s stock currently trades for $17.00 per share, what is the expected rate of return?

a- 692.65%

b- 19.24%

c- 612.49%

d- 1,563.53%

Walter’s dividend is expected to grow at a constant growth rate of 6.00% per year. What do you expect to happen to Walter’s expected dividend yield in the future?

a- It will decrease.

b- It will stay the same.

c- It will increase.

Answer 1

1). Statement B is true. Increasing dividends may not always increase the stock price, because less earnings may be invested back into the firm and that impedes growth.

This is because, Dividend is one of the factor affecting price in DDM model, but Required return or risk of the company is also a factor. Many company do not pay dividend because they reinvest the earnings. Instead if company has free cash flow, they pay dividends and if they pay dividend from the earnings, investment in the company will be less.

2). Given D1 = $2.25

Price P0 = $17

growth rate of dividend = 6%

So, using constant dividend growth model,

P0 = D1/(rs-g)

17 = 2.25/(rs - 0.06)

=> rs = 19.24%

option B is correct.

3). if growth rate and expected return does not change for a stock, Dividend yield for the company does not changes and it will stay the same. This is because, dividend and price both increases by the same growth rate.

So, option b is correct.