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
Dividend Discount Model
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