Question

The constant growth valuation formula has dividends in the numerator. Dividends are divided by the difference between the required return and dividend growth rate as follows:
P0P0 = = D1rs−gD1rs−g
1. Which of the following statements is true?

A. Increasing dividends will always decrease the stock price, because the firm is depleting internal funding resources.
B. Increasing dividends will always increase the stock price.
C. Increasing dividends may not always increase the stock price, because less earnings may be invested back into the firm and that impedes growth.

2. Walter Utilities is a dividend-paying company and is expected to pay an annual dividend of $0.85 at the end of the year. Its dividend is expected to grow at a constant rate of 9.50% per year. If Walter’s stock currently trades for $20.50 per share, then the expected rate of return on the stock is:

A. 9.56%
B. 13.65%
C. 11.60%
D. 17.75%

3. Walter’s dividend is expected to grow at a constant growth rate of 9.50% per year. What do you expect to happen to Walter’s expected dividend yield in the future?

A. It will increase.
B. It will decrease.
C. It will stay the same.

Answer 1

Answer:

1. C

2. B. 13.65%.

Explanation:

1. Some of the portion of Earnings After Tax is given out to Shareholders in the form of Dividends and some of it is retained for growth Purposes. As the Retained Earnings are used for expansion and growth, that's why the formula for Growth is (ROE)*(Retention Ratio). When companies pay out large amount of dividends, it is left with minimal amount for retention which affects its growth rate and the rate tends to decrease.

If you look at the model of Constant Growth, also given in the question, the Growth Rate is deducted in Denominator. A lower growth rate will increase the denominator value and hence the stock price will go down.

2. Rearrange the formula for Constant Growth:

P0 = D1 / (Ke - g) OR Ke = (D1/P0) + g

⇒ Ke = (.85/20.5) + .095 = .1365 OR 13.65%.