The AZ Company currently has $1,000,000 in physical assets that have always generated a steady stream of earnings for the company. The management of the firm has always paid all of its earnings to shareholders as a dividend. While there is risk in the return on assets, the average return over many years has been steady at 10 percent. The firm has 500,000 shares outstanding. The current ex-dividend price of a share of equity is $1.75 (i.e., at this price, a buyer does not get the current dividend just paid but must wait a year for the next dividend).
a. If the firm pays out all of its annual earnings as dividends, what will be the dividend paid per share?
b. What is the required rate of return (demanded by shareholders of this firm) implied by the current market price?
c. The management wants the company to grow. Rather than pay out all of the firm’s earnings as a dividend this year (t = 0), the management wants to plow back 40 percent of the earnings into the business. Assuming that the management will be able to maintain the return on assets it has achieved in the past (i.e., 10%) as the firm grows, what will be the ex-dividend stock price under the new growth policy? Fill in the following table and refer to appropriate entries when calculating the price.
d. Should the management adopt the payout policy described in c above? Why or why not?
e. Under the 40 percent plowback policy, what is the present value of growth opportunities?