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 $2.40, K_e is 13 percent, and g is 5 percent.
Under Plan A, D₀ would be immediately increased to $3.00 and K_e and g will remain unchanged.
Under Plan B, D₀ will remain at $2.40 but g will go up to 6 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 $3.00 (1.05). K_e will equal 13 percent, and g will equal 5 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 $2.40 (1.06). K_e will be equal to 13 percent, and g will be equal to 6 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)

Year 1 dividend = 3 (1.05) = 3.15

Price of stock today = Year 1 dividend / required rate - growth rate

Price of stock today = 3.15 / 0.13 - 0.05

Price of stock today = 3.15 / 0.08

Price of stock today = $39.38

b)

Year 1 dividend = 2.4 (1.06) = 2.544

Price of stock today = Year 1 dividend / required rate - growth rate

Price of stock today = 2.544 / 0.13 - 0.06

Price of stock today = 2.544 / 0.07

Price of stock today = $36.34

c)

plan A has the higher value