Carew Inc. traditionally has retained 40% of its annual earnings to finance reinvestments. The firm has historically earned a real return of 11% per annum on its reinvestments. The required (real) rate of return on Carew stock is also 11% per annum. Carew has just announced a new investment opportunity that it will finance by forgoing paying the dividend of $3.30 per share that otherwise would have been paid imminently.
(a) What should have been the price of Carew stock immediately before the announcement when investors would have been entitled to receive the anticipated $3.30 dividend and would have expected Carew to continue managing its affairs as it had always done?
Carew also announced that as a result of the new project the dividend paid in one year’s time will now be $3.50 and it will grow at the rate of 9% per year for 5 more years, then 6% per year for 3 additional years before returning to the traditional growth rate based on Carew’s historical return on investments and its policy of retaining 40% of its earnings for reinvestment. Carew said that it will continue to maintain its traditional investment of retained earnings in its on-going business. The new opportunity has the same risk as its existing investments.
(b) What would happen to the price of Carew’s stock upon announcement of the new project and dividend and earnings retention arrangements?