Question

Sidman Products's common stock currently sells for $70 a share. The firm is expected to earn $8.40 per share this year and to pay a year-end dividend of $3.80, and it finances only with common equity.

1. If investors require a 12% return, what is the expected growth rate? Do not round intermediate calculations. Round your answer to two decimal places.

     %

2. If Sidman reinvests retained earnings in projects whose average return is equal to the stock's expected rate of return, what will be next year's EPS? (Hint: g = (1 – Payout ratio)ROE). Do not round intermediate calculations. Round your answer to the nearest cent.

   $   per share

Answer 1

(a)

The required growth rate is calculated as follows:

Cost of equity= (Expected Dividend/Stock price) + growth rate

12%= (3.8/70) + growth rate

growth rate= 6.57%

(b)

Retained earnings per share= Expected EPS - Expected dividend = $8.4 - $3.8= $4.6 per share

If the return on investment is equal to expected rate of return i.e. 12%, the next year's EPS is calculated as follows:

Next year's EPS= Current year's EPS + Retained earnings*12% = $8.4 + $4.6*12% = $8.95