Corporate Finance 2 questions

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Principles of Corporate Finance + S&P Market Insight (10th Edition)

Problem

Consider the following two statements: “Dividend policy is irrelevant,” and “Stock price is the present value of expected future dividends.” (See Chapter 4.) They sound contradictory. This question is designed to show that they are fully consistent.

The current price of the shares of Charles River Mining Corporation is $50. Next year’s earnings and dividends per share are $4 and $2, respectively. Investors expect perpetual growth at 8% per year. The expected rate of return demanded by investors is r = 12%. We can use the perpetual-growth model to calculate stock price:

Suppose that Charles River Mining announces that it will switch to a 100% payout policy, issuing shares as necessary to finance growth. Use the perpetual-growth model to show that current stock price is unchanged.

Step-by-step solution

Dividend discount model is a stock valuation method using the predicted dividends and discounting it to the present value.

Comment

The current share price of CRM Corporation is $50. Next year’s earnings per share (EPS) are $4 and dividends per share (DPS) are $2. Perpetual growth rate is 8% per year. Expected rate of return is 12%. CRM Corporation is planning to change the payout policy to 100% payout policy.

Comment

Calculation of stock price to know whether the current stock price changes or remains the same

Original dividend policy:

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Under the original dividend policy, the next year’s stock price can be calculated as follows:

Assuming that the company has ‘n’ number of outstanding shares, the value of the company for the next year will be $54n.

Comment

New dividend policy:

Under the new policy, ‘n’ new shares will be issued in the year t is 1, to reduce the retained earnings in new policy.

This decrease in the retained earnings is $2, per original share.

Alternatively, the total amount will be $2n.

Comment

If P1 is the price of the common stock at t is 1 under the new policy, then:

Comment

Calculate the value of P1 as follows:

Comment

Calculate the price of the share under the new policy at the year t is 0:

If g is the expected growth rate under the new policy and P0 the price at t is 0. From the above

calculation, the price of the share in the next year is $52.

Comment

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Recommended solutions for you in Chapter 16

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As per the perpetual growth model, the price of the share is calculated as follows:

Comment

Equaling the above two equations, find the growth rate, g for price of the stock (P0) as follows:

Hence, growth rate is 4%.

Comment

Substitute the value of growth rate in the formula to get price of stock (P0) as follows:

Hence, the current stock price is unchanged and remains $50 .

Comment

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Chapter 16, Problem 10P

Little Oil has outstanding 1 million shares with a total market value of $20 million. The firm is expected to pay $1 million of...

See solution

Chapter 16, Problem 23P

Consider the following two statements: “Dividend policy is irrelevant,” and “Stock price is the present value of expected...

See solution

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