stock earnings

Question

A firm's stock earns $2 per share, and the firm distributes 40 percent of its earnings as cash dividends.  Its dividends grow annually at 7 percent.

a.) What is the stock's price if the required return is 10 percent?

b.) The firm borrows funds and, as a result, its per share earnings and dividends increase by 20 percent.  What happens to the stock's price if the growth rate and the required return are unaffected?  What will the stock's price be if after using financial leverage and increasing the dividend to $1, the required return rises to 12 percent?  What may cause this required return to rise?

Answer 1

a

Cash dividend per share = 0.4 * 2 = 0.8

Stock price under the dividend growth model = 0.8/(0.1-0.07) = 26.67

 

b

Stock price increases by 20%.

Stock price = 1/(0.12-0.07) = 20

Need a higher return to offset the cost of borrowing (financial leverage).