Question

Explain work in detail please (include formulas and show your logic)

The stock of Hobbit Corporation is currently selling for $10 per share. Earnings per share in the coming year are expected to be $2. 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 20% rate of return per year. This situation is expected to continue indefinitely.

1. Assuming the current market price of the stock reflects its value, what rate of return do Hobbit’s investors require?
2. By how much does its value exceed what it would be if all earnings were paid as dividends and nothing was reinvested?
3. What is the PVGO for this company?
4. If Hobbit were to cut its dividend payout ratio to 25%, what would happen to its stock price?
5. What did you notice about the relationship between Hobbit’s dividend payout policy and its price?
6. What do you think is the reason for such a relationship?

Answer 1

a. Po = D1/ Re - g

D1 = 50% * 2

=$1

Po = $1/ Re - g

Growth rate = retention ratio * return on equity

= 0.5* 0.2

= 10%

So, Po = $1/ Re - 0.1

10 = $1/ Re - 0.01

10(Re - 0.01) = 1

10 Re -0.1 = 1

10 Re = 2

Re =20%

The required rate of return by the shareholders is 20%.

b. If all earnings are paid out as dividends ,

Po = D1/ Re - g

= $2/ 0.2 - 0.1

= $20

It's value is going to increase by 100% if it is going to pay all its earnings as dividends.

c. PVGO = Stock price - earnings/cost of equity

= $10 - $2/ 0.2

= 0

d. Po = D1/ Re - g

=$0.5/ 0.2 - 0.1

= $5

If it cuts the dividends, the stock price is going to fall by 50%.

e. The higher the dividend payout policy, the higher the stock price will be .

f. Investors love dividend paying stock,they pay a higher price for stocks which pay a higher dividend.