a. Company XYZ forecasts to pay a GHc 8.33 dividend next year, which represents

Question

a. Company XYZ forecasts to pay a GHc 8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plough back 40% of the earnings at the firm’s current return on equity of 25%. What is the value of the stock before and after the plough back decision?

b. What will be the nominal rate of return on a preferred stock with a $100 par value, a stated dividend of 8 percent of par value, and current market price of (i) $160 (ii) $80

Explanation / Answer

1

Before plowback decision, assuming that dividend is constant at 8.33

Price=D1/(r-g)

D1=8.33

r=15%

g=0

Price=8.33/0.15=55.53

After plowback, growth=RoE*(1-plowbackratio)=25%*(1-40%)=15%

Price=8.33/(0.15-0.15)=infinite..so, we have to use other model to forecast the price

2

Preferred stock price=Dividend/return

i) Hence, 160=100*8%/return

so, return=5%

ii) Hence, 80=100*8%/return

so, return=10%

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