Question

Security valuation: equity:

Next year, a company expects net income of $44 million. It pays 50% of its earnings out in dividends and has a cost of equity capital of 11%.

a. If the company's NI has a 7% growth rate, what is the estimated value of your company?

b. What is its re-investment rate (i.e. internal rate of return on earnings retained and reinvested)?

Now suppose instead that the company's re-investment rate (i.e. internal rate of return) on all future retained earnings is only 11%, and continue to assume initial earnings of $44 million.

c. What would be the value of the company if it maintains a dividend payout ratio of 50%?

d. Does the value of the company in c. above change if the payout ratio is reduced to 25%? Why or why not?

e. Find the company's market capitalization one year from now under each of the two dividend policies described in c. and d. Which payout policy leads to a greater increase in stock price?

f. How can the seemingly contradictory results obtained in parts d. and e be reconciled

Answer 1

a) Value of Company = dividend - Ke- growth Dividend pay Ratio = $44 million x 50 % 0.11 - 0.07 = $ 22 million 0.04 | $550 million b) Re-investment growth rate = 7 Rate Retention ratio 50% 14° c) STEP 1: calculate new growth rate" growth = Retention Ratio x Rot = 50 % x 11 = 5.5%. STEP 2: calculate value of company. Value = Earnings x DPR = 44 m x 50% = $ 400 million Ke-g 0.11 -0.055

d) Yes, the value will change as the amount of dividend will get reduced and the value of compony is just the present value of dividends.