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 $2.00, K_e is 10 percent, and g is 5 percent.
Under Plan A, D₀ would be immediately increased to $2.20 and K_e and g will remain unchanged.
Under Plan B, D₀ will remain at $2.00 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 $2.20 (1.05). K_e will equal 10 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 $2.00 (1.06). K_e will be equal to 10 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 A

• Plan B

Answer 1

Plan A

D0 =2.20

Growth rate (g) =5%

required return (ke) =10%

D1 = D0*(1+g)

=2.20*(1+5%) =2.31

Price of stock as per constant growth model formula = D1/(ke-g)

2.31/(10%-5%)

=46.2

So Price of stock today (P0) will be $46.2 under Plan A

Plan B

D0 =2.0

Growth rate (g) =6%

required return (ke) =10%

D1 = D0*(1+g)

=2*(1+6%) =2.12

Price of stock as per constant growth model formula = D1/(ke-g)

2.12/(10%-6%)

=53

So Price of stock today (P0) will be $53 under Plan B

Plan B produces Higher stock price. So we should choose Plan B