Question

DFB, Inc., expects earnings this year of $5.48 per​ share, and it plans to pay a $3.96 dividend to shareholders. DFB will retain $1.52 per share of its earnings to reinvest in new projects with an expected return of 14.8% per year. Suppose DFB will maintain the same dividend payout​ rate, retention​ rate, and return on new investments in the future and will not change its number of outstanding shares.

a. What growth rate of earnings would you forecast for​ DFB?

b. If​ DFB's equity cost of capital is 11.5%​, what price would you estimate for DFB​ stock?

c. Suppose DFB instead paid a dividend of $4.96 per share this year and retained only $0.52 per share in earnings. That​ is, it chose to pay a higher dividend instead of reinvesting in as many new projects. If DFB maintains this higher payout rate in the​ future, what stock price would you estimate​ now? Should DFB follow this new​ policy?

The question has four parts. Please answer every part for a thumbs up.

Answer 1

a). Retention Ratio(b) = Addition to retained earnings / Net Income

= $1.52/$5.48 = 0.2774, or 27.74%

g = ROE*b = 14.8%*0.2774 = 4.11%

b). P0 = D1/(r-g) = $3.96/(0.115-0.411) = $3.96 / 0.0739 = $53.55

c). New Retention Ratio(b) = Addition to retained earnings / Net Income

= $0.52/$5.48 = 0.0949, or 9.49%

g = ROE*b = 14.8%*0.0949 = 1.04%

P0 = D1/(r-g) = $4.96/(0.115-0.0104) = $4.96 / 0.1010 = $49.13

No, projects are positive NPV (return exceeds cost of capital), so do not raise the dividend.