Question

Computer stocks currently provide an expected rate of return of 17%. MBI, a large computer company, will pay a year-end dividend of $2.20 per share. a. If the stock is selling at $52 per share, what must be the market's expectation of the dividend growth rate? (Round your answer to 2 decimal places.) Growth rate % b. If dividend growth forecasts for MBI are revised downward to 7% per year, what will happen to the price of MBI stock? The price will rise. The price will fall. c. What (qualitatively) will happen to the company's price-earnings ratio? The price-earnings ratio will rise. The price-earnings ratio will fall.

Answer 1

Current market price=(Year end dividend)/(Expected rate of return-Constant growth rate)
Current market price=(2.2)/(17%-Constant growth rate)

Part a:
Answer: Growth rate=12.77%

If the stock is selling at $52 per share, the current market price is $52
=>52=(2.2)/(17%-Constant growth rate)
=>(17%-Constant growth rate)=(2.2)/52     
=>17%-(2.2)/52=Constant growth rate
=>Constant growth rate=0.17-0.042307692=0.1276923 or 12.77% (Rounded to two decimal places)

Part b:
Answer: Price will fall

When growth forecasts is 7%, the price will be:
Current market price=(2.2)/(17%-7%)
=2.2/10%
=22
So, the revised share price will be $22

Part c:
Answer: The price earnings ratio will fall

PE ratio=(Price per share)/(Earnings per share)
So, when the price falls from $52 to $22 the numerator in the ratio will be less, so the price earnings ratio will also fall