Green Gadgets Inc. is trying to decide whether to cut its expected dividend for

Question

Green Gadgets Inc. is trying to decide whether to cut its expected dividend for next year from $9 per share to $6 per share in order to have more money to invest in new projects. If it does not cut the dividend, Green Gadgets' expected rate of growth in dividends is 5 percent per year and the price of their common stock will be $95 per share. However, if it cuts its dividend, the dividend growth rate is expected to rise to 8 percent in the future. Assuming that the investor's required rate of return for Green Gadgets' stock does not change, what would you expect to happen to the price of its common stock if it cuts the dividend to $6? Should Green Gadgets cut its dividend?

Explanation / Answer

Required rate of return is calculated below using before dividend cut data.

Required rate of return = (Expected Dividend / Current price) + Growth rate

= ($9 / $95) + 5%

= 9.47% + 5%

= 14.47%.

Required rate of return si 14.47%.

Now After dividend cut,

Expected dividend = $6.

Growth rate = 6%.

Stock price after dividend cut = $6 / (14.47% - 8%)

= $6 / 6.47%

= $92.74.

Stock price after dividend cut is $92.74% which is loer than stock price before dividend Cut.

So company should not cut dividend.

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