12) Gate 5 Corporation expects earnings per share of $10 in the coming year. Rat

Question

12) Gate 5 Corporation expects earnings per share of $10 in the coming year. Rather than reinvest these earnings, it plans to pay its earnings as dividend. With no growth, Gate 5 current share is $105.26. Assume that Gate 5 cuts it dividend payout rate to 60% and use the retained earnings to open new distribution centers. The return on investment in these centers is expected to be 15%. If the risk is equivalent, then the equity cost of capital is unchanged. Determine Gate 5 new price? a) $285.71 b) $63.16 c) $105.26 d) $171.43

Explanation / Answer

Cost of equity, r = D / P = 10 / 105.26 = 9.50%

Growth rate = ROI x (1 - payout ratio) = 15% x (1 - 60%) = 6%

Dividend next year, D1 = 10 x 60% = 6

Price today, P0 = D1 / (r - g) = 6 / (9.5% - 6%) = $171.43

Hence, d is correct.

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