Question

Expected returns, dividends, and growth

The constant growth valuation formula has dividends in the numerator. Dividends are divided by the difference between the required return and dividend growth rate as follows:

Pˆ0P̂0

=  =

D1(rs – g)D1(rs – g)

Which of the following statements is true?

Increasing dividends may not always increase the stock price, because less earnings may be invested back into the firm and that impedes growth.

Increasing dividends will always decrease the stock price, because the firm is depleting internal funding resources.

Increasing dividends will always increase the stock price.

Walter Utilities is a dividend-paying company and is expected to pay an annual dividend of $2.25 at the end of the year. Its dividend is expected to grow at a constant rate of 6.50% per year. If Walter’s stock currently trades for $20.00 per share, what is the expected rate of return?

1,385.00%

734.38%

660.56%

17.75%

Walter’s dividend is expected to grow at a constant growth rate of 6.50% per year. What do you expect to happen to Walter’s expected dividend yield in the future?

It will decrease.

It will stay the same.

It will increase.

Answer 1

The correct statement is

Increasing dividends may not always increase the stock price, because less earnings may be invested back into the firm and that impedes growth.

Stock price is not only dependent on dividend, but on growth as well

Stock Price = Expected Dividend/(Required return – growth rate)

20 = 2.25/(Expected return – 6.50%)

Expected return = 17.75%

It will stay the same.

Since dividend yield = Expected Dividend/Current price

Since growth rate is same, dividend yield will stay the same