Computer stocks currently provide an expected rate of return of 16% MBI, a largo

Question

Computer stocks currently provide an expected rate of return of 16% MBI, a largo computer company, will pay a year-end dividend of $4 per share If the slock is soiling at $60 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.) Growth rate | % If dividend growth forecasts for MBI are revised downward to 6% per year. what will be the price of the MBI stock? (Round your answer to 2 decimal places.) Price $ What (qualitatively) will happen to the company's price earnings ratio? Increases Decreases

Explanation / Answer

(a)Formula to calculate the current share price by dividend discount method

Stock Price P = D1 / (k – g)

Where:

P = the current stock price = $ 50
D1 = dividend for year = $ 4 per share
k = required rate of return = 16% or 0.16
g = growth rate of dividends = ?

Therefore

$ 50 = $ 4 / (0.16 – g)

Or (0.16 – g) = 4 / 50 = 0.08

Or   g = 0.16 – 0.08 = 0.08 or 8 %

The dividend growth rate is 8%.

(b-1) if dividend growth rate of the stock is 6 % instead of 8% then the price of the stock

P = 4 / (0.16 – 0.06) = 4 / 0.1 = $ 40

(b-2) the price to earnings ratio will decrease as the price of the share decreases from $ 50 to $40

Price earnings ratio P/E = Price of the stock/ earnings per share

Suppose if earnings per share is constant then an increase or decrease in the price of share will increase or decrease the price earnings ratio respectively.

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