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valuation of common stocks

The stock of Slogro Corporation is currently selling for $10 per share. Earnings per share in the coming year are expected to be $2 per share. The company has a policy of paying out 60% of its earnings each year in divedends. The rest is retained and invested in projects that earn a 20% rate of return per year. This situation is ex[pected to continue forever.

a. Assuming the current market price of the stock reflects its intrinsic value as computed using the constant growth rate DDM, waht rate of return do Slogro's investors require?

b. By how much does its value exceed what it would be if all earnings were paid as dividends and nothing were reinvested?

c. If Slogro were to cut its dividend payout ratio to 25%, what would happen to its stock price? What if Slogro eliminated the dividend altogether?

d. Suppose that Slogro wishes to maintain its current 60% dividend payout policy but that it also wishes to invest an amount each year equal to that year's total way that Slogro could do so would be to issue an amount of new stock each year equal to one-half that year's earnings. What do you think would be the effect of this policy on the current stock price?

Solution Preview


a. P0 = $10, E1 = $2, b = .4, ROE = .2

k = D1/P0 + g

D1 = .6 x $2 = $1.20

g = b x ROE = .4 x .2 = .08

Therefore, k = $1.20/$10 + .08 = ...

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