Question

Management action and stock value REH​ Corporation's most recent dividend was $ 2.56 per​ share, its expected annual rate of dividend growth is 5​%, and the required return is now 15​%. A variety of proposals are being considered by management to redirect the​ firm's activities. Determine the impact on share price for each of the following proposed actions. a.  Do​ nothing, which will leave the key financial variables unchanged. b.  Invest in a new machine that will increase the dividend growth rate to 6​% and lower the required return to 14​%. c.  Eliminate an unprofitable product​ line, which will increase the dividend growth rate to 6​% and raise the required return to 18 %. d.  Merge with another​ firm, which will reduce the growth rate to 4​% and raise the required return to 19​%. e. Acquire a subsidiary operation from another manufacturer. The acquisition should increase the dividend growth rate to  9 % and increase the required return to 18​%.

Answer 1

Answer (a)

Most recent dividend = $2.56

Expected annual rate of dividend growth is = 5​%

Dividend next year = $2.56 * (1 + 5%)

Required return is = 15​%

Share price = Dividend next year / (Required Return - Constant growth rate)

= $2.56 * (1 + 5%) /(15% - 5%)

= $26.88

Share price = $26.88

Answer (b)

Share price = $2.56 * (1 + 6%) / (14% - 6%)

= $33.92

Impact:

Share price increases to $33.92

Answer (c)

Share price = $2.56 * (1 + 6%) / (18% - 6%)

= $22.61

Impact:

Share price decreases to $22.61

Answer (d)

Share price = $2.56 * (1 + 4%) / (19% - 4%)

= $17.75

Impact:

Share price decreases to $17.75

Answer (e)

Share price = $2.56 * (1 + 9%) / (18% - 9%)

= $31

Impact:

Share price increases to $31