Problem 5. The dividend growth model is used by many investors to value stock. U
ID: 2738555 • Letter: P
Question
Problem 5. The dividend growth model is used by many investors to value stock. Using the dividend-payout ratio, and the sustainable growth rate equation in the dividend growth model, calculate the price of a share of stock today, using the following dividend growth model equation. Then use your results to explain whether the firm should pay a dividend or expand its manufacturing capability.
The dividend-payout ratio is one minus b, where b is the retention ratio; the dividend next year will be the earnings next year, E1, times one, minus the retention ratio: P0 = E1(1–b).
The sustainable growth rate is the return on equity times the retention ratio: Rs – ROE x b. The dividend growth model equation for calculating the price of a share of stock today is:
P0 = E1(1–b) /Rs – ROE x b
Explanation / Answer
Ans.:)
Market Price of the share = E (1-b) / (k - br)
E = Earnings per share
D = Earnings * Dividend Payout ratio
K = Cost of equity
br = Retion ratio * Return on investment
if r > k the firm shall be advisable to retain the earnings not to distributed as dividend (i.e payout ratio is to be decreased) because the return on investment is higher than the cost of equity .i.e benefit to the firm
if r < k the firm shall be advisable to Distribute the total earnings distributed as dividend (i.e payout ratio is to be increased) because the return on investment is lower than the cost of equity .i.e loss to the firm
if r = k this is nuetral situation decession is depends upon firm i.e either to hold or distribute the earnings.
Note : Here in question there is no information about actual figures so i concluded this question with respect to above concept.
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