Computer stocks currently provide an expected rate of return of 24%. MBI, a larg

Question

Computer stocks currently provide an expected rate of return of 24%. MBI, a large computer company, will pay a year-end dividend of $3.60 per share. If the stock is selling at $66 per share, what must be the market's expectation of the growth rate of MBI dividends? (Do not round intermediate calculations. Round your answer to 2 decimal places. Omit the "%" sign in your response.) If dividend growth forecasts for MBI are revised downward to 11 % per year, what will happen to the price of MBI stock? What (qualitatively) will happen to the company's price-earnings ratio?

Explanation / Answer

P=D/k-g
Where: P=security's price; D=dividend payout ratio; k=required rate of return (derived from the capital asset pricing model; g=dividends' expected growth rate.

a)

Here P = $66 and D = $3.6 and g is the growth rate to be calculated when k is 24%

$66 = $3.6/(0.24-g)

0.24-g = $3.6/$66

g = 0.24 - 0.545 = 0.18545 = 18.545%

b-1) if g = 11% then P = $3.6/(0.24-0.11)

Price = $27.692

b-2) Price earnings ratio = price per share / earnings per share.

Hence the growth rate is dropping from 18.5% to 11%, the market price of the share is dropping from $66 to $27 hence qualitatively price-earnings ratio will fall considering constant earnings per share

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