Problem: Eastern Telecom is trying to decide whether to increase its cash dividend immediately or use the funds to increase its future growth rate. It will use the dividend valuation model for analysis purposes.
The model formula is as follow:
P0 = __D1___
Ke - g
P0 = Price of stock
D1 = Dividend at the end of the first year
D0 x (1xg)
D0= Dividend today
Ke= Require rate of return
g= Constant growth rate in dividends
D0 is currently $3.00, Ke is 10 percent, and g is 5%.
Under Plan A, D0 would be immediately increased to $3.40 and Ke and g will remain unchanged.
Under Plan B, D0 will remain at $3.00 but g will go up to 6% and Ke will remain unchanged.
a) Compute 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 to 10% and g will equal 5%.
b) Compute 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 equal to 10% percent and g will equal 6%.
c) Which plan will produce the higher value?