Question

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? (Assume that the new expansion does not change Cooperton’s risk.) Is the expansion a good investment?

Answer 1

Answer: Share price after announcement is $41.67.

The Expansion is not a good investment.

Explanation:

To solve this we would need to first calculate the cost of equity. Given the Initial stock price as well as the dividend and growth rate, we are able to calculate the cost of equity using the Gordon Growth Formula which is,

Sp = D1/ (r - g)

Where,

Sp is stock price

D1 is the next dividend

r is cost of equity

g is growth rate.

Inserting the figures we have,

50 = 4 / ( r - 3%)

50 ( r - 3%) = 4

r = 4/50 + 3%

r = 11%

Given that we now know r, we can calculate the new stock price using the same formula,

Sp = D1/ ( r - g)

Sp = 2.5 ( 11% - 5%)

Sp = $41.67

The stock price after the announcement became $41.67.

The Expansion is NOT a good investment as it leads to a reduction in Stock Price.