The stock of Nogro Corporation is currently selling for $30 per share. Earnings

Question

The stock of Nogro Corporation is currently selling for $30 per share. Earnings per share in the coming year are expected to be $6. The company has a policy of paying out 40% 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. 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.)

Rate of return %

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

PVGO $

Explanation / Answer

According to the constant growth DDM, the required rate of return = D1/P0 + g where

D1 is the dividend next year. D0 = 0.4* 6 = 2.4. D1 will be 2.4*1.2 = 2.88 Since the growth is ast 20%

P0 = $30

g= 20% =0.2

Hence Required rate of return = 2.88/30 + 0.2 = 0.296 = 29.6%

B. If everything was paid out as dividends, the the D1 will be 6*1.2 = 7.2

Hecne rate will be 7.2/30 + 0.2 =0.44 =44%

Hence the value exceed by 44-29.6 = 14.4%

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