Question

DFB, Inc. expects earnings this year of $4.02 per share, and it plans to pay a $2.27 dividend to shareholders at that time (one year from now). DFB will retain $1.75 per share of its earnings to reinvest in new projects that have an expected return of 14.6% per year. Suppose DFB will maintain the same dividend payout rate, retention rate, and return on new investments in the future and will not change its number of outstanding shares. a. What growth rate of earnings would you forecast for DFB? b. If DFB's equity cost of capital is 11.3%, what price would you estimate for DFB stock today? c. Suppose, instead, that DFB paid a dividend of $3.27 per share this year and retained only $0.75 per share in earnings. If DFB maintains this higher payout rate in the future, what stock price would you estimate for the firm now? Should DFB raise its dividend? a. DFB's growth rate of earnings is . (Round to one decimal place.) b. If DFB's equity cost of capital is 11.3%, then DFB's stock price will be S (Round to the nearest cent.) c. If DFB paid a dividend of $3.27 per share this year and retained only $0.75 per share in earnings, then DFB's stock price would be $ (Round to the nearest cent.) Should DFB raise its dividend? (Select the best choice below.) O A. No, DFB should not raise dividends because companies should always reinvest as much as possible. O B. Yes, DFB should raise dividends because, according to the dividend-discount model, doing so will always improve the share price. O C. No, DFB should not raise dividends because its projects have a positive NPV. O D. Yes, DFB should raise dividends because the return on new investments is lower than the cost of capital

Answer 1

a. Growth rate of earnings is computed by using the below formula:

= retention rate x return on equity

Retention rate is computed as follows:

= ( EPS - DPS ) / EPS

= ( $ 4.02 - $ 2.27 ) / $ 4.02

= 43.53% Approximately

Return on equity = 14.6% or 0.146

So by plugging these values in the above mentioned formula, we shall get:

= 0.4353 x 0.146

= 6.4% Approximately

b. DFB's stock price is computed as shown below:

= Expected dividend / ( cost of capital - growth rate )

= $ 2.27 / ( 0.113 - 0.064 )

= $ 46.33 Approximately

c. DFB's stock price is computed as shown below:

= Expected dividend / ( cost of capital - growth rate )

Growth rate is computed as shown below:

= retention rate x return on equity

Retention rate is computed as follows:

= ( EPS - DPS ) / EPS

= ( $ 4.02 - $ 3.27 ) / $ 4.02

= 18.66% Approximately

Return on equity = 14.6%

So the growth rate will be:

= 0.1866 x 0.146

= 2.72% Approximately

So the price will be:

= $ 3.27 / ( 0.113 - 0.0272 )

= $ 38.11 Approximately

d. The correct answer will be option c i.e. no, DFB should not raise dividends because the projects are positive NPV.

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