Question

The stock of Nogro Corporation is currently selling for $10 per share. Earnings per share in the coming year are expected to be $2. The company has a policy of paying out 50% of its earnings each year in dividends. The rest is retained and invested in projects that earn a 20% rate of return per year. This situation is expected to continue indefinitely.
A. Assuming the current market price of the stock reflects its value, what rate of return do Nogro’s investors require?
B. By how much does its value exceed what it would be if all earnings were paid as dividends and nothing were reinvested?
C. What is the PVGO for this company?
D. If Nogro were to cut its dividend payout ratio to 25%, what would happen to its stock price?
E. What did you notice about the relationship between Nogro’s dividend payout policy and its price?
F. What do you think is the reason for such relationship?

Answer 1

Answer:

Check below for the solution.

Explanation:

A) Earning Per Share, EPS = $2

Dividend Pay out ratio = 50%

Required rate of return = (Expected Dividend next year / Current selling price) + Growth Rate

Expected Dividend per share next year = EPS x Dividends pay-out ratio

Expected Dividend per share next year =  $2 x 50% = $2 * 0.5

Expected Dividend per share next year  = $1

Return on Equity, ROE =  EPS / Current selling price

ROE = $2 / $10 = 0.20 = 20%

Growth Rate = ROE x (1-Dividend pay-out ratio)

Growth Rate = 0.20 x (1-0.50) = 0.10 = 10%

 Required Rate of Return = (Expected Dividend next year / Current selling price) + Growth Rate

Required Rate of Return =  ($1 / $10) + 0.10 = 0.20 = 20%

B) If all the earnings are paid as dividends, there won’t be any amount left to invest for growth and hence there won’t be any growth in the company. Also, since the required Rate of Return is equal to its ROE, there won’t be any changes.

C) Present Value of Growth Opportunity (PVGO) = 0

This is because with all earnings paid out as dividends, there won’t be any growth and the required rate of return will be equal to the ROE.

D) Since the ROE is equal to required rate of return, there won’t be any impact of cutting down the dividends pay-out. The residual income with lesser pay-out ratio will be invested by the company in available projects that is expected to earn 20% and ROE is also same. Since, there is no changes in the earnings figures, the stock price would remain $10.

E) There is no relationship between Nogro’s dividend payout policy and its price as no impact is experienced in its share prices due to change in its dividend policy.

F) This is because the ROE and the required rate of return are equal.