Question: Eastern Telecom is trying to decide whether to raise its cash dividend immediately or use the funds to raise its future growth rate. It will use the dividend valuation model originally presented in Chapter ten for purposes of analysis. The model was shown as Formula 10-9 and is reproduced below.
[With a slight addition in definition of terms]
P0 - D1
Ke - g
D1 - Dividend at the end of the 1st year
P0 - Price of the stock today
Ke - Required rate of return
D0 x (1 x g)
D0 - Dividend today
g - Constant growth rate in dividends
D0 is currently $3.00, Ke is 10%, & g is 5%.
Under Plan A, D0 would be immediately increased to $3.40 & Ke and g will remain unchanged.
Under Plan B, D0 will remain at $3.00 but g will go up to 6% & Ke will remain unchanged.
[A] Calculate P0 (price of the stock today) under Plan A. Note D1 will be equal to D0 x (1 + g) or $3.40 (1.05). Ke will equal 10% and g will equal 5%.
[B] Calculate P0 (price of the stock today) under Plan B. Note D1 will be equal to D0 x (1 + g) or $3.00 (1.06). Ke will be equal to 10% & g will be equal to 6%.
[C] Which plan will produce the higher value?