Question

DFB, Inc. expects earnings this year of $4.49 per share, and it plans to pay a $2.55 dividend to shareholders at that time (one year from now). DFB will retain $1.94 per share of its earnings to reinvest in new projects that have an expected return of 15.4% 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 11.5%, what price would you estimate for DFB stock today? c. Suppose, instead, that DFB paid a dividend of $3.55 per share this year and retained only $0.94 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 11.5%, then DFB's stock price will be $ . (Round to the nearest cent.) c. If DFB paid a dividend of $3.55 per share this year and retained only $0.94 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 its projects have a positive NPV. OB. No, DFB should not raise dividends because companies should always reinvest as much as possible. O C. Yes, DFB should raise dividends because the return on new investments is lower than the cost of capital. OD. Yes, DFB should raise dividends because, according to the dividend-discount model, doing so will always improve the share price.

Answer 1

Answer a.

Retention Ratio, b = Earnings Retained / Expected Earnings
Retention Ratio, b = $1.94 / $4.49
Retention Ratio, b = 0.4321

Return on Equity, ROE = 15.40%

Growth Rate, g = ROE * b
Growth Rate, g = 15.40% * 0.4321
Growth Rate, g = 6.7%

Answer b.

Cost of Capital, k = 11.50%
Expected Dividend, D1 = $2.55

Current Price, P0 = D1 / (k - g)
Current Price, P0 = $2.55 / (0.115 - 0.067)
Current Price, P0 = $2.55 / 0.048
Current Price, P0 = $53.13

Answer c.

Retention Ratio, b = Earnings Retained / Expected Earnings
Retention Ratio, b = $0.94 / $4.49
Retention Ratio, b = 0.2094

Return on Equity, ROE = 15.40%

Growth Rate, g = ROE * b
Growth Rate, g = 15.40% * 0.2094
Growth Rate, g = 3.2%

Cost of Capital, k = 11.50%
Expected Dividend, D1 = $3.55

Current Price, P0 = D1 / (k - g)
Current Price, P0 = $3.55 / (0.115 - 0.032)
Current Price, P0 = $3.55 / 0.083
Current Price, P0 = $42.77

No, DFB should not raise dividends because companies should always reinvest as much as possible.