Problem: Pigeon Express currently plows back 40 percent of its earnings and earns a return of 20 percent on this investment. The dividend yield on the stock is 4 percent.
1) Assuming that Pigeon can continue to plow back this proportion of earnings and earn a 20 percent return on the investment, how rapidly will earnings and dividends grow? What is the expected return on Pigeon stock?
2) Suppose that management suddenly announces that future investment opportunities have dried up. Now Pigeon intends to pay out all its earnings. How will the stock price change?
3) Suppose that management simply announces that the expected return on new investment will in the future be the same as the market capitalization rate. Now what is Pigeon stock price?