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Q: Financial Analysis ( Answered,   0 Comments )
Subject: Financial Analysis
Category: Business and Money > Finance
Asked by: grant53-ga
List Price: $10.00
Posted: 29 Jul 2006 12:46 PDT
Expires: 28 Aug 2006 12:46 PDT
Question ID: 750679
Constant-Growth Model. Here are data on two stocks, both of which have
discount rates of 15 percent:
 	               Stock A	Stock B
Return on equity	15%	10%
Earnings per share	$2.00	$1.50
Dividends per share	$1.00	$1.00
A.	What are the dividend payout ratios for each firm? 
B.	What are the expected dividend growth rates for each firm? 
C.	What is the proper stock price for each firm?
Subject: Re: Financial Analysis
Answered By: elmarto-ga on 30 Jul 2006 16:46 PDT
a. The dividend payout ratio is calculated as:
(Dividends per Share) / (Earnings per Share)

Thus, for firm A, this ratio is 1/2 = 50%. For firm B, the ratio is 1/1.5 = 66.66%

b. The expected dividend growth rate is calculated using the following formula:
Dividend Growth Rate = (Retention Ratio)*(Return on Equity)

The Retention Ratio is simple one minus the dividend payout ratio. So
the retention ratio is 50% for firm A and 33.33% for firm B.
Therefore, their growth rates will be:

Dividend Growth for Firm A = 0.5*0.15 = 0.075   (annual 7.5%)
Dividend Growth for Firm B = 0.3333*0.1 = 0.03333?  (annual 3.33%)

c. Here we use the constant dividend growth pricing model. The formula is:

Price = (Next Dividend) / (Discount Rate - Growth Rate).

Notice that both firms currently pay $1 per share. Let?s assume that
this dividend was paid yesterday for both firms. Thus the next
dividend for firm A will be 1.075, and for firm B it will be 1.0333.
Therefore, using the given formula  and bearing in mind that the
discount rate is 15% for both firms, we get:

Price(Firm A) = 1.075/(0.15 - 0.075) = $14.33
Price(Firm A) = 1.0333/(0.15 - 0.0333) = $8.85

Additional Resources:
Dividend Discount Model

Google search terms
constant dividend growth model formula

I hope this helps! If you have any doubt regarding my answer, please
don't hesitate to request clarification before rating it. Otherwise, I
await your rating and final comments.

Best wishes!
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