Chapter 5: Q16BP (page 599)

Question: Omni 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 here (with a slight addition in definition of terms):
P0 = D1/Ke – g
P0 = Price of the stock today
D1 = Dividend at the end of the first year D0 X (1+1 g)
D0 = Dividend today
Ke = Required rate of return
g = Constant growth rate in dividends
D0 is currently $2.50, Ke is 10 percent, and g is 5 percent.
Under Plan A, D0 would be immediately increased to $3.00 and Ke and g will remain unchanged.
Under Plan B, D0 will remain at $2.50 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 $3.00 (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 D0 X (1 + g) or $2.50 (1.06). Ke will be equal to 10 percent, and g will be equal to 6 percent.
c. Which plan will produce the higher value?

Expert verified

Answer

The stock price will be $63 in plan A and $66.25 in plan B. Plan B will provide higher value of stock price.

Step by step solution

The stock price will be $63.

$D_{1} = D_{0} (1 + g) = $ 3 (1.05) = $ 3.15$

$P_{0} = \frac{D 1}{K_{e} - g} = \frac{$ 3.15}{1 - 0.5} = $ 63$

The stock price will be $66.25.

$D 1 = D_{0} (1 + g) = $ 2.50 (1.06) = $ 2.65$

$P_{0} = \frac{D_{1}}{K_{e} - g} = \frac{$ 2.65}{1 - 0.06} = $ 66.25$

The plan B will provide higher stock value as the stock price will be $66.25, whereas, the stock price in plan A will be $63.

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Bailey corporation
Income statement
For the year 20X1
Sales (all on credit)	\(42,680,000
Cost of goods sold	\)32,240,000
Gross profit	\(10,440,000
Selling and administrative expenses	\)4,558,000
Operating profit	\(5,882,000
Interest expense	\)600,000
Net income before taxes	\(5,282,000
Taxes	\)2,120,000
Net income	\(3,162,000

Bailey corporation
Balance sheet
As of December 31, 20X1
Assets
Current assets:
Cash	\)250,000
Marketable securities	\(130,000
Accounts receivables	\)6,000,000
Inventory	\(8,300,000
Total current assets	\)14,680,000
Net plant and equipment	\(13,970,000
Total assets	\)28,650,000
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	\(3,800,000
Notes payable	\)3,550,000
Total current liabilities	\(7,350,000
Long-term liabilities	\)5,620,000
Total liabilities	\(12,970,000
Stockholder’s equity:
Common stock (1,800,000 shares at \)1 par)	\(1,800,000
Capital in excess of par	\)6,300,000
Retained earnings	\(7,580,000
Total stockholder’s equity	\)15,680,000
Total liabilities and stockholder’s equity	\(28,650,000

Bailey corporation
Income statement
For the year 20X1
Sales (all on credit)	\(42,680,000
Cost of goods sold	\)32,240,000
Gross profit	\(10,440,000
Selling and administrative expenses	\)4,558,000
Operating profit	\(5,882,000
Interest expense	\)600,000
Net income before taxes	\(5,282,000
Taxes	\)2,120,000
Net income	\(3,162,000

Bailey corporation
Balance sheet
As of December 31, 20X1
Assets
Current assets:
Cash	\)250,000
Marketable securities	\(130,000
Accounts receivables	\)6,000,000
Inventory	\(8,300,000
Total current assets	\)14,680,000
Net plant and equipment	\(13,970,000
Total assets	\)28,650,000
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	\(3,800,000
Notes payable	\)3,550,000
Total current liabilities	\(7,350,000
Long-term liabilities	\)5,620,000
Total liabilities	\(12,970,000
Stockholder’s equity:
Common stock (1,800,000 shares at \)1 par)	\(1,800,000
Capital in excess of par	\)6,300,000
Retained earnings	\(7,580,000
Total stockholder’s equity	\)15,680,000
Total liabilities and stockholder’s equity	$28,650,000

Liabilities and stockholder’s claims
Liabilities
Accounts payable	\(2,800,000
First lien, secured by machinery and equipment	\)900,000
Senior unsecured debt	\(2,200,000
Subordinated debenture	\)1,700,000
Total liabilities	\(7,600,000
Stockholder’s claims
Preferred stock	\)250,000
Common stock	\(650,000
Total stockholder’s claims	\)900,000
Total liabilities and stockholder’s claims	$8,500,000