Problem:
Dividend valuation model and wealth maximization Managial Finance II 476 text problem
Eastern Telecom is trying to decide whether to increase its cash dividend immediately or use the funds to increase its future growth rate. It will use the dividend valuation model originally presented in Chapter 10 for purposes of analysis. The model was shown as Formula 10-9 and is reproduced below (with a slight addition in definition of terms).
P0 =
P0 = Price of the stock today
D1 = Dividend at the end of the first year
D0 = (1 x g)
D0 = Dividend today
Ke = Required rate of return
g = Constant growth rate in dividends
D0 is currently $3.00, Ke is 10 percent, and g is 5 percent.
Under Plan A, D0 would be immediately increased to $3.40 and Ke and g will remain unchanged.
Under Plan B, D0 will remain at $3.00 but g will go up to 6 percent and Ke will remain unchanged.
a. Compute P0 (price of the stock today) under Plan A. Note D1 will be equal to D0 x (1 + g) or $3.40 (1.05). Ke will equal 10 percent and g will equal 5 percent.
b. Compute P0 (price of the stock today) under Plan B. Note D1 will be equal to 6 percent.
c. Which plan will produce the higher value?