The stock of Nogro Corporation is currently selling for $20 per share. Earnings

Question

The stock of Nogro Corporation is currently selling for $20 per share. Earnings per share in the coming year are expected to be $2.00. The company has a policy of paying out 70% of its earnings each year in dividends. The rest is retained and invested in projects that earn a 18% rate of return per year. This situation is expected to continue indefinitely. Assuming the current market price of the stock reflects its intrinsic value as computed using the constant-growth DDM, what rate of return do Nogoro's investors require? By how much does its value exceed what it would be if all earnings were paid as dividends and nothing were reinvested? If Nogro were to cut its dividend payout ratio to 60% , what would happen to its stock price?

Explanation / Answer

a) Price = next dividend/( cost of equity - growth rate)

20 = (2*0.7) /(cost of equity - 0.18*.3)

required rate(cost of equity)= 12.4%

where growth rate = project return *(1-dividend rate)

b) Price if all earnings are paid out :next dividend/( cost of equity - growth rate)

(2) /(0.124 - 0.18*0) = 16.129

price exceeds by 20-16.129 = 3.87

c)

Price :next dividend/( cost of equity - growth rate)

(2*.6) /(0.124 - 0.18*.4) = 23.0769

Price will increase

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