Company Q’s current return on equity (ROE) is 14%. It pays out one-half of earnings as cash dividends (payout ratio = .5). Current book value per share is $50. Book value per share will grow as Q reinvests earnings.
Assume that the ROE and payout ratio stay constant for the next four years. After that, competition forces ROE down to 11.5% and the payout ratio increases to 0.8. The cost of capital is 11.5%.
a. What are Q’s EPS and dividends next year? How will EPS and dividends grow in years 2, 3, 4, 5, and subsequent years?
b. What is Q’s stock worth per share? How does that value depend on the payout ratio and growth rate after year 4?
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