Omni Telecom is trying to decide whether to increase its cash dividend immediate

Question

Omni Telecom is trying to decide whether to increase its cash dividend immediately or use the funds to increase its future growth rate.

P0 = D1 /Ke ? g

P0 = Price of the stock today

D1 = Dividend at the end of the first year

D1 = D0 × (1 + g)

D0 = Dividend today

Ke = Required rate of return

g = Constant growth rate in dividends

D0 is currently $2.00, Ke is 8 percent, and g is 4 percent. Under Plan A, D0 would be immediately increased to $2.50 and Ke and g will remain unchanged. Under Plan B, D0 will remain at $2.00 but g will go up to 5 percent and Ke will remain unchanged.

a. Compute P0 (price of the stock today) under Plan A. Note D1 will be equal to D0 × (1 + g) or $2.50 (1.04). Ke will equal 8 percent, and g will equal 4 percent. (Round your intermediate calculations and final answer to 2 decimal places.)

b. Compute P0 (price of the stock today) under Plan B. Note D1 will be equal to D0 × (1 + g) or $2.00 (1.05). Ke will be equal to 8 percent, and g will be equal to 5 percent. (Round your intermediate calculations and final answer to 2 decimal places.)

Explanation / Answer

This question uses constant growth dividend discount model, the formula for which are already in question. Let us apply that for the question:

a) D1 = D0 * (1 + g)

but D0 is increased to $2.50

D1 = 2.50 * (1 + 4%) = $2.60

P0 = 2.60/(8% - 4%) = $65 per share

b) D1 = D0 * (1 + g)

D1 = 2.00 * (1 + 5%) = $2.10

P0 = 2.10/(8% - 5%) = $70 per share

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