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Appropriate Discount and Inflation Rate

The fund you represent is a significant shareholder in Iron Man Industries which just paid a dividend of $5.25 per share is currently expected to grow in perpetuity at 5% each year. Management has proposed a significant re-structuring of the business which will cost a lot of capital, only part of which can be raised externally. They are proposing that the board of directors suspend dividend payments for 2 years to finance the re-organization after which (in year 3), dividends of $5.00 per share will be re-instated. The re-organization will also cost the firm $100 million in the first year, and $80 million in year 2. This re-organization however will enable dividends to grow at 7% a year from that point forward in perpetuity.

1. If the appropriate discount rate is 11% under either alternative and the firm has 40,000,000 shares outstanding, should you vote to support the re-organization or not?

2. Assume now that inflation is 1% higher and that the discount rate rises appropriately. How do you feel about the re-organization now?

Solution Preview

1. We should calculate the value per share in each alternative to make the decision. We use the dividend discount model for the calculation
Value = D1/(required return - growth rate)
Without restructuring -
D0 = current dividend = 5.25
growth rate = 5%
D1 = expected ...

Solution Summary

The solution discusses stock questions regarding appropriate discount rate and inflation rate.