Chapter 5: Q15BP. (page 598)

Question: The Vinson Corporation has earnings of $500,000 with 250,000 shares outstanding. Its P/E ratio is 20. The firm is holding $300,000 of funds to invest or pay out in dividends. If the funds are retained, the aftertax return on investment will be 15 percent, and this will add to present earnings. The 15 percent is the normal return anticipated for the corporation, and the P/E ratio would remain unchanged. If the funds are paid out in the form of dividends, the P/E ratio will increase by 10 percent because the stockholders in this corporation have a preference for dividends over retained earnings. Which plan will maximize the market value of the stock?

Short Answer

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Answer

The market value of the stock will be higher, i.e., $44 when the funds are distributed as dividend to the shareholders.

Step by step solution

Information provided in the question

Earnings = $500,000

Shares outstanding = 250,000

P/E ratio = 20

Funds available = $300,000

Calculation of market value of stock in case of retained earnings

The market value of stock will be $43.60

$I n c r e m e n t e a r n i n g s = A f t e r - t a x r e t u r n \times f u n d s a v a i l a b l e = 15 % \times $ 300, 000 = $ 45, 000 E P S = \frac{E a r n i n g s + I n c r e m e n t e a r n i n g s}{S h a r e s o u t s \tan d i n g} = \frac{$ 500, 000 + $ 45, 000}{250, 000} = \frac{$ 545, 000}{250} = $ 2.18 S t o c k p r i c e = \frac{P}{E} r a t i o \times E P S = 20 \times $ 2.18 = $ 43.60$

Calculation of market value of stock in case of pay-out

The market value of stock will be $44.

N e w \frac{P}{E} r a t i o = I n c r e a s e i n \frac{P}{E} r a t i o \times O l d \frac{P}{E} r a t i o = 110 % \times 20 = 22 E P S = \frac{E a r n i n g s}{S h a r e s o u t s \tan d i n g} = \frac{$ 500, 000}{250, 000} = $ 2 S t o c k p r i c e = \frac{P}{E} r a t i o \times E P S = 22 \times $ 2 = $ 44

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Calculation of market value of stock in case of retained earnings

Calculation of market value of stock in case of pay-out

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