Question

Joe Schmoe & Co expects its dividends to be $85,000 every other year forever, with the first payment occurring two years from today. The firm can borrow at an EAR of 11%, currently has no debt, and has an effective annual cost of equity of 18%. The corporate tax rate is 35%. Assume tax credits for losses and no financial distress costs.
(a) Calculate the value of the firm.
(b) What will firm value be if it borrows $60,000 in permanent debt with annual coupon payments and uses the proceeds to repurchase its shares?

M&M Inc has just paid an annual dividend of $2.40 per share and current market expectations are for dividends to grow at 6%. The required return on the firm’s stock is 14%.
(a) What is the firm’s share price today?
(b) What is the firm’s share price one year from today?
(c) Find the future value of your answer to part (a) by compounding it at the required return for a year. Why is this result different from your answer to part (b)?
(d) Suppose management announces tomorrow that next year’s dividend is going to be $2.50 per share. Assuming constant dividend growth continues to apply, describe how share price will change, if at all. Does your answer suggest that dividend policy matters? Explain by making reference to your stock valuation model.

Answer 1

M&M Inc

1. Firm’s Share price today: Dividend / (Rate of return – Growth Rate)

: $ 2.40 / (0.14 - 0.06)

: $ 2.40 / 0.08

: $ 30

2. Firm's Share price year from today : Dividend *(1+ Growth Rate) / (Rate of return – Growth Rate)

: $2.4 *(1+0.06) / (0.14 - 0.06)

: $ 2.544 / 0.08

: $ 31.8

3. Future Value compounding at Rate of return of 14% for a Year: FV = PV (1+r)

= $30 (1+0.14)

= $ 34.2

The result is different from part b beacuse , in part B , we are calculating the future price of the dividends only , the stock price will increase only by the increased dividend amount. Whereas, in part c, we are calculating the future price of the stock if we are getting the rate of return @14%. The price of stock will increase by 14%.