Question

6. Newbanks Corporation net income this year is $800,000. The company generally retains 35% of net income for reinvestment. The company's common stock currently has a book value of $5,000,000. They just paid a dividend of $2.37, and the required rate of return on this stock is 12%. Compute the value of this stock if dividends are expected to continue growing indefinitely at the company's sustainable growth rate.
a) $22.61
b) $18.42
c) $15.63
d) $39.11

Answer 1

Retention Ratio = 35 %, Net Income = $ 800000 and Book Value of Common Equity = $ 5000000

ROE = Net Income / Book Value of Common Equity = 800000 / 5000000 = 0.16 or 16 %

Therefore, Sustainable Growth Rate = Retention Ratio x ROE = 0.35 x 0.16 = 0.056 or 5.6 %

Current Dividend = D0 = $ 2.37

Expected Dividend = D1 = 2.37 x 1.056 = $ 2.50272

Required Return = ke = 12 %

Therefore, Stock Price = D1 / (ke - growth rate) = 2.50272 / (0.12 - 0.056) = $ 39.105 or $ 39.11 approximately.

Hence, the correct option is (d).