Question

The FI Corporation's dividends per share are expected to grow indefinitely by 5% per year.

a. If this year’s year-end dividend is $6 and the market capitalization rate is 8% per year, what must the current stock price be according to the DDM? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Current stock price            $

b. If the expected earnings per share are $12, what is the implied value of the ROE on future investment opportunities? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Value of ROE             %

c. How much is the market paying per share for growth opportunities (that is, for an ROE on future investments that exceeds the market capitalization rate)? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Amount per share            $

Answer 1

a.

Value of stock paying growing dividend = Next dividend/(Capitalization rate-Growth rate)

Current stock price = $6/(0.08-0.05) = $200 per share

b.

Dividend payout ratio = Dividend per share/Earnings per share = $6/$12 = 50%

Retention ratio = 1 – Dividend payout ratio = 1 – 0.50 = 0.50

Return on equity = Growth rate / Retention ratio = 5% / 0.50 = 10%

c.

Price per share on basis of ROE = EPS/ROE = $12/10% = $120

Price paid more for growth opportunities = $200 - $120 = $80