Company's current return on equity is 14%. It pays out one half of earnings as cash dividends (payout ratio = .5). Current book value per share is $50. Book value per share will grow as the company reinvests earnings.
Assume that the ROE and payout ratio stay constant for the next four years. After that, competition forces ROE down to 11.5% and the payout ratio increases to 0.8. The cost of capital is 11.5%.
a. What are the company's EPS and dividends next year? How will EPS and dividend grow in years 2,3,4,5 and subsequent years?
b. What is the company's stock worth per share? How does that value depend on the payout ratio and growth rate after year 4?
The solution solves the below problem using the dividend discount model.