A firm’s stock earns $2 per share, and the firm distributes 40 percent of its earnings as cash dividends. Its dividends grow annually at 4 percent.
a) What is the stock’s price if the required return is 8 percent?
b) The firm borrows funds and, as a result, its per-share earnings and dividends increase by 20 percent. What happens to the stock’s price if the growth rate and the required return are unaffected? What will the stock’s price be if after using financial leverage and increasing the dividend to $1, the required return rises to 10 percent? What may cause this required return to rise?