A motor manufacturer (ticker RPM) currently pays out 40% of their annual net income, retaining the rest for further investments in new opportunities. The estimated return on equity (ROE) of these new projects is 12%.
a. Estimate the dividend growth rate, assuming that the payout ratio and expected returns on investment stay constant.
b. Next year’s expected dividend is $0.66 per share. If the market requires a 15% expected return on the firm’s equity, what is your estimate of the current stock price of RPM?
c. If the firm decided to cut its investment and instead pay out 100% our annual earnings in dividends, what do you expect would be the new price of RPM stock?
d. Why would the market respond positively to this announcement, i.e. why did the stock price increase? Hint: If you did not find that the stock price in part c is higher than the price found in part b, you may want to re-check your numbers.