Tricky question

Current share price: \$40.00 52-week high/low: \$43.50 / \$36.25 Market capitalization: \$2.25 billion Book value: \$1.8 billion Tax rate: 35% After-tax cost of debt (kd): 4.25% Cost of retained earnings (ks): 8.00% 2005 earnings: \$100.125 million Estimated 2006 earnings: \$112.5 million Constant growth rate (g): 5.2% stock currently does not pay a dividend. Assuming that forward earnings, the cost of debt, and the constant growth rate of the firm could be maintained, which of the following would be most likely to increase stock price to \$50 per share? A. Initiation of a \$0.40 per share dividend in 2006 that would lower the cost of equity (ks) by 1.8%. B. A special dividend of \$50 million. C. Initiation of a \$0.80 per share dividend in 2006 that would lower the cost of equity (ks) by 1.2%. D. Moving the firm from a country with a double-taxation system where corporate profits are taxed at 35% to a country with a tax imputation system where individual tax rates are 15%.

C. I used a single stage DDM. .8/(6.8%-5.2%) If you think about it a special dividend cant possible raise the stock price so B is out. D doesnt make any sense. A is wrong because using the same methodology above you get 40

Dapper, your correct. My question is why would you use the return on equity and not WACC, When do you know to use WACC and when do you know to use retun on equity for the DDM?

DDM always uses required return on equity.

I believe you always use the required return on equity for the DDM. This is because you are valuing share price on the perspective of an equity holder and want the equity value. Equity value is different than firm value (think FCFF model where you discount with WACC vs. FCFE model where you discount with req eq return). This model just happens to be based on the dividend. Hope that helps.

Can you explain how this lowers the cost of equity?

Wow, that clears it up and definitely won’t make that mistake on the exam now. Thanks

Actually can someone spell this whole thing out for me?

mwvt9, here is the actual solution: Market capitalization = current price × shares outstanding \$2,250,000,000 = \$40 × shares outstanding Shares outstanding = 56,250,000 Kazmaier’s forward earnings are estimated to be \$112.5 million. Based on 56,250,000 million shares, forward earnings on a per share basis are (\$112,500,000 / 56,250,000) = \$2.00 per share. Based on the current \$40 stock price, the leading P/E ratio is \$40.00/\$2.00 = 20. If Kazmaier were to initiate a dividend and the cost of equity drops, we can use the constant growth dividend discount model to estimate the P/E for the firm. If Kazmaier initiates a dividend in the amount of \$0.80, resulting in a drop in the cost of equity (ks) of 1.2%, the firm’s dividend payout ratio would be (\$0.80 / \$2.00) = 40%, and the cost of equity would be (8.0% – 1.2%) = 6.8%. The P/E ratio based on forward earnings would be: Po/E1 = (D1/E1) / (k-g) = 0.4/(0.068-0.052) = 25 With a P/E ratio based on forward earnings of 25, and forward earnings of \$2.00 per share, the resulting stock price would be 25 × \$2.00 = \$50 per share. You could make an argument that either a special dividend or a switch to a different tax regime could possibly increase the stock price, but the best answer is “C” because the stock price turns out to be exactly \$50 based on the inputs to the valuation model.

mwvt9, I think I know what you are asking. When I did the question i just plugged in the numbers it gave me though without really thinking of that relationship. Here’s my take on it…When a firm issues a dividend they are guaranteeing at least some return to investors making the investment less risky (at least in theory right?).

I guess cost of equity drops because when your giving shareholders a dividend, their required return on the equity drops. Can someone please verify this.

Thanks.

I think my way is a bit quicker

Dapper425 Wrote: ------------------------------------------------------- > mwvt9, > > I think I know what you are asking. When I did the > question i just plugged in the numbers it gave me > though without really thinking of that > relationship. Here’s my take on it…When a firm > issues a dividend they are guaranteeing at least > some return to investors making the investment > less risky (at least in theory right?). I can see the logic, I just haven’t seen another question that has the cost of equity drops when a dividend is initiated.

you guys blow my mind…period! Helps a lot though…better than blow my own brains off with a gun! Thanks a lot guys.