Question

Company ABC forecasts to have a earning per share of $8 next year. If the company distributes all its earnings to shareholders as dividends, it will provide investors with a 10% expected return. Instead, company ABC decides to plowback 35% of the earnings at the firm’s current return on equity of 20%. What is the value of the stock before and after the plowback decision? Shall your calculation steps. If you use the financial calculator, tell me your inputs and output (i.e. pv,fv,n, i/Y, pmt).

please write the equation and solve step by step

Answer 1

Value of the stock before=(D0/ke)

Dividend at the beginning of the year=8

Ke=rate of return required by investor= 10%

Value of the stock before={ 8/10%}= 80

Value of the stock after the retention ratio have been applied.

Growth rate of dividend=( return on equity*retention rate)

={ 20%*35%}= 7%

g= 7%

Amount of dividend payable=8(1-.35)= 5.2

It is so because 35% of the dividend has been retained.

Calculation of share price= D0/(Ke-g)

=5 .2/(10%-7%)

= [5.2/3%]

= 173.33