Question

The stock of Nogro Corporation is currently selling for $20 per share. Earnings per share in the coming year are expected to be $6. The company has a policy of paying out 50% of its earnings each year in dividends. The rest is retained and invested in projects that earn a 30% rate of return per year. This situation is expected to continue indefinitely.

a. Assuming the current market price of the stock reflects its intrinsic value as computed using the constant-growth DDM, what rate of return do Nogro’s investors require? (Do not round intermediate calculations.)

b. By how much does its value exceed what it would be if all earnings were paid as dividends and nothing was reinvested?

c. If Nogro were to cut its dividend payout ratio to 25%, what would happen to its stock price?

• Stock price would be decreased

• Stock price would be unaffected

• Stock price would be increased

d. If Nogro eliminated the dividend, what would happen to its stock price?

• Stock price would be decreased

• Stock price would be increased

• Stock price would be unaffected

Answer 1

As per Dividend Discount Model, Value of Stock = Expected Dividend/(Required Return – Growth Rate)

Growth rate = ROE*Retention Ratio

=30%*50%

=15%

Hence,

20 = 3/(Required Return – 15%)

Hence, required return = 30%

b.In nothing is reinvested, growth rate = 0

Dividend per share = $6

Value = 6/30%

= $20

Hence, value remains the same

c.Value = 1.5/(30%-22.5%)

= $20

Stock price would be unaffected

d.Stock price would be unaffected

Since, the return earned by the company on equity is equal to the investor’s required rate of return, the change in dividend payout ratio will not affect the share price