According to constant growth dividend discount model, we compute the intrinsic value of stock at time 0 (today’s computed stock price), P0=D1/(k-g), where D1 is the expected dividend next year, and k is the required return or discount rate. Assuming the required return is 20% per year.
a. If we assume dividend will grow at a constant rate of 8% infinitely. The stock price is $35 per share. If we assume the stock is correctly priced, i.e., the stock has intrinsic value equal to its market price, what is the dividend the firm is paying to its shareholders this year?
Hint: D1=D0*(1+g).
b. Instead of assuming that the firm will have a constant dividend growth ratio of 8%, if we assume that the firm will have ROE (return on asset) of 15% per year, expected EPS (earns per share, E1) of $2.50, and the dividend payout ratio of 60%. Will you buy or sell the stock?
c. The firm just makes an announcement that it expects its future ROE will be altered. Immediately after the announcement, the stock price surges 20%. Will the expected ROE greater or smaller than 15%? Why?