House of Haddock has 5,000 shares outstanding and the stock price is $140. The c

Question

House of Haddock has 5,000 shares outstanding and the stock price is $140. The company is expected to pay a dividend of $20 per share next year and thereafter the dividend is expected to grow indefinitely by 5% per year. The president, George Mullet, now makes a surprise announcement: He says that the company will henceforth distribute half the cash in the form of dividends and the remainder will be used to repurchase stock.

Q: What is the total value of the company before and after the announcement, and what is the value of one share?

Explanation / Answer

Using the Gordon growth model

140= 20/(r- .05)
r= .192857 (expected return in the stock)

So at 140 per share the total value of the company is 140*5,000 = 700,000

If the dividend growth rate is cut to 2.5%

P= 20/(.192857-.025)= 119.14 (one share)
So value of the company is now 595,745.

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