REH Corporation\'s most recent dividend was $3 per share, its expected annual ra
ID: 2718442 • Letter: R
Question
REH Corporation's most recent dividend was $3 per share, its expected annual rate of dividend growth is 5%, and the required return is now 15%. A variety of proposals are being considered by management to redirect the firm's activities. Determine the impact on share price for each of the following proposed actions, and indicate the best alternative.
a. Do nothing, which will leave the key financial variables unchanged.
b. Invest in a new machine that will increase the dividend growth rate to 6% and lower the required return to 14%.
c. Eliminate an unprofitable product line, which will increase the dividend growth rate to 7% and raise the required return to 17%.
d. Merge with another firm, which will reduce the growth rate to 4% and raise the required return to 16%.
e. Acquire a subsidiary operation from another manufacturer: The acquisition should increase the dividend growth rate to 8% and increase the required return to 17%.
Please show the equations.
Explanation / Answer
Answer (a)
If firm does nothing, Expected Share price = $ 31.50
Anwewr (b)
Invest in a new machine, Expected Share price = $ 39.75
Answer (c)
Eliminate an unprofitable product line, Expected Share price =$ 32.10
Answer (d)
Merge with another firm, Expected Share Price = $ 26
Answer (e)
Acquire a subsidiary, Expected Share Price = $ 36
Most Recent Dividend = $ 3 per share
Expected annual rate of dividend growth = 5%
Required rate of return = 15%
Dividend next year = $ 3* 1.05 = $ 3.15
Share price = $ 3.15 / (0.15 – 0.05) = $ 3.15 / 0.10 = $ 31.50
Invest in a new machine
Dividend growth rate = 6%
Required rate of return = 14%
Next year dividend = $ 3 * 1.06 = $ 3.18
Share Price = $ 3.18 / (0.14 – 0.06) = $ 3.18 /0.08 = $ 39.75
Eliminate unprofitable product line
Dividend growth rate = 7%
Required return = 17%
Share Price = ($3 * 1.07) /(0.17 – 0.07) = $ 3.21 / 0.10 = $ 32.10
Merge with another firm
Dividend growth rate = 4%
Required return = 16%
Share Price = ($ 3 * 1.04) / (0.16 – 0.04) = $ 3.12 /0.12 = $ 26
Acquire a subsidiary
Dividend growth rate = 8%
Required rate of return = 17%
Expected share price = ($ 3 * 1.08) / (0.17 – 0.08) = $ 3.24 / 0.09 = $ 36
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