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2008
1.
DFB, Inc. expects earnings this year of $5 per share, and it plans to pay $3
dividend to shareholders. DFB will retain $2 per share of its earnings to reinvest
in new project that have an expected return of 15% 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 shares outstanding.
a.
What growth rate of earnings would you forecast for DFB?
ൌ ൈ ൌ
ൈ . ൌ . ൌ %
b.
If DFB’s cost of equity capital is 12%, what price would you estimate for
DFB stock?
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ൌ
$
. െ .
ൌ $
c.
Suppose instead that DFB paid a dividend of $4 per share this year, and
retained only $1 per share in earnings. If DFB maintains a higher payout
rate in the future, what stock price would you estimate for the firm now?
Should DFB raise its dividend?
Assuming that the expected return on investment is still 15%, the lower
retention rate translates into lower growth:
ൌ ൈ ൌ
ൈ . ൌ .
ൌ %
Given this expected growth rate, next year’s dividend will be $4×1.03 =
$4.12, and the stock price will be:
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െ
ൌ
$.
. െ .
ൌ $. ૠૡ
No, projects are positive NPV (return exceeds cost of capital), so don’t
raise dividend.
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2.
Cooperton Mining just announced it will cut its dividend from $4 to $2.50 per
share and use the extra funds to expand. Prior to the announcement, Cooperton’s
dividends were expected to grow at a 3% rate, and its share price was $50. With
the planned expansion, Cooperton’s dividends are expected to grow at a 5% rate.
What share price would you expect after the announcement? Is the expansion a
positiveNPV investment?
Since the price was $50 prior to the announcement with an expected growth rate
of 3%, we can solve for Cooperton’s cost of equity capital:
ൌ
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.
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After the announcement,
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.
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In this case, cutting the dividend will reduce the stock price to $41.67. The move
to cut the dividend and to expand is not positive NPV. Do not do it.
3.
ColgatePalmolive Company has just paid an annual dividend of $0.96. Analysts
are predicting an 11% per year growth rate in earnings over the next five years.
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 Fall '08
 Croce
 Capital Asset Pricing Model, Corporate Finance, Net Present Value, Dividend yield

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