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Lengefeld Manufacturing expects to have earnings per share of $7 in the coming year
Lengefeld Manufacturing expects to have earnings per share of $7 in the coming year. Instead of reinvesting these earnings the firm plan to pay out all of its earnings as dividends. With these expectations of no growth the Lengefeld's current stock price is 70$. Suppose if the firm plans to pay out 60% of its earnings as a dividend for indefinite future and use the retained earnings to open a new outlet. The return of investment on the new outlet is expected to be 14%. What effect would this new policy have on Lengefeld's stock price? Assume that the risk level of the new and existing investment are same. (7 points)
Expert Solution
As all earnings are paid out,
growth rate in dividends = g = growth rate = 0%
So for no growth firm, cost of equity = ke = Dividend/Price = 7/70 = 10%
Now suppose firm pays 60% dividend, 40% will be retained
So b = 40% , ROE = 14%
so g = growth rate = b x ROE = 40% x 14% = 5.60%
D1 = dividend = 7 x 60% = 4.20
So price of stock with 5.60% dividend growth will be
P0 = D1/(ke -g) = 4.20/(0.10-0.056) = 95.45
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