One of the most important rules of investing is that investors demand returns wh
ID: 2744686 • Letter: O
Question
One of the most important rules of investing is that investors demand returns which compensate them for the risk to which they are being exposed. For this example, assume that the dividend/stock price ratio is a proxy for this risk/return relationship that investors require. The dividend/stock price ratio is known as the Dividend Yield. Use these rules as a basis for your answer: Any decision that improves EPS will also improve the stock price. If the risk of the firm remains constant, then the dividend / stock price ratio will remain constant. If the risk of the firm increases, then an adjustment will have to be made to the ratio to improve the investor's percentage return. If the risk of the firm decreases, then an adjustment will occur which reduces the investor's percentage return. Dividend Yield = Dividend ($) / Stock Price ($) T. Boone Farms, Inc. has just acquired another firm which has a very successful product line, strong management, and a healthy balance sheet. T. Boone Farms, Inc. expects its EPS to increase about 10%. However, the firm intends to maintain its current payout ratio. The financial risk of the combined firm will remain unchanged. T. Boone Farm's stock price will likely A) increase. B) decrease. C) remain unchanged.
Explanation / Answer
It is given that
Given dividend yield=Dividend/Stock price.
EPS is expected to grow 10%.
The firm is intending to maintain its current payout ratio and also the financial risk of the combined firm remains same, but the EPS is going to rise by 10%, So, the stock price will increase because the When EPS increases stock price alsoo increases other things remaining constant ie., Dividend yield and risk remaining constant.
Hence, the answer is a) increase.
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