Question

DFB, Inc. expects earnings next year of $5 per share, and it plans to pay a $3 dividend to shareholders (assume that is one year from now). DFB will retain $2 per share of its earnings to reinvest in new projects 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 outstanding shares. Assume next dividend is due in one year. If DFB's equity cost of capital is 12%, what price would you estimate for DFB stock

Answer 1

Answer:

$50

Explanation:

The price of the stock can be estimated using the constant growth dividend model

the constant dividend growth model

price = d1 / (r - g)

d1 = next dividend to be paid

r = cost of equity

g = growth rate

growth rate = retention rate x ROE  

Retention rate = 1 - payout ratio

ROE = Return on equity = 15%

Payout ratio = dividend per share / earning per share

Payout ratio = 3/5 = 0.6

Retention rate = 1 - 0.6 = 0.4

growth rate = 0.4 x 15 = 6%

Price of the stock = 3 / (0.12 - 0.06)

3/0.06 = $50