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    Example of Dividend Decrease and Price Decrease. 2. Takeover Example

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    1. When a company decreases its dividend, its stock price often decreases as well, as the dividend cut may signal underlying problems at the firm. 2. A takeover example shows a firm with a 10% return on equity reinvesting 60% of earnings, but its cost of capital is 15%. Its price of $22.22 is less than its no-growth value of $33.33, indicating another firm could buy it and pay out all earnings instead of reinvesting. 3. Stock prices do not always rise when dividends are cut, as the dividend cut may reveal issues making the firm's actual returns less than its cost of capital.

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    Example of Dividend Decrease and Price Decrease. 2. Takeover Example

    Uploaded by

    sanchi
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    1. When a company decreases its dividend, its stock price often decreases as well, as the dividend cut may signal underlying problems at the firm. 2. A takeover example shows a firm with a 10% return on equity reinvesting 60% of earnings, but its cost of capital is 15%. Its price of $22.22 is less than its no-growth value of $33.33, indicating another firm could buy it and pay out all earnings instead of reinvesting. 3. Stock prices do not always rise when dividends are cut, as the dividend cut may reveal issues making the firm's actual returns less than its cost of capital.

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    1. When a company decreases its dividend, its stock price often decreases as well, as the dividend cut may signal underlying problems at the firm. 2. A takeover example shows a firm with a 10% return on equity reinvesting 60% of earnings, but its cost of capital is 15%. Its price of $22.22 is less than its no-growth value of $33.33, indicating another firm could buy it and pay out all earnings instead of reinvesting. 3. Stock prices do not always rise when dividends are cut, as the dividend cut may reveal issues making the firm's actual returns less than its cost of capital.

    Copyright:

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    6 views8 pages

    Example of Dividend Decrease and Price Decrease. 2. Takeover Example

    Uploaded by

    sanchi
    1. When a company decreases its dividend, its stock price often decreases as well, as the dividend cut may signal underlying problems at the firm. 2. A takeover example shows a firm with a 10% return on equity reinvesting 60% of earnings, but its cost of capital is 15%. Its price of $22.22 is less than its no-growth value of $33.33, indicating another firm could buy it and pay out all earnings instead of reinvesting. 3. Stock prices do not always rise when dividends are cut, as the dividend cut may reveal issues making the firm's actual returns less than its cost of capital.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
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    of 8

    1.

    Example of dividend decrease and price


    decrease.
    2. Takeover example
     
    • Inputs -- plant and equipment = 100 million all
    equity financed.
    • ROE = 15%
    • ROE = .15 * 100 million = 15 million.
    • If there are 3 million shares outstanding
    this represents $5 per share in earnings.
    • Capitalization rate (required return) = 12.5%
    • If 60% of the 15 million is reinvested then this
    represents $9 million increase in the firm’s capital.
    • g = ROE xb = .15 x .6 = .09
    • P= D1/(k-g)  Now if 60% is retained then 40% is
    paid out so dividends are now $2.
    • 
    • P= 2/(.125-.09) = 57.14
    • The no retention ( plowback) price is P = 5/.12.5 =
    $40
    • 
    • There the price reflects $ 17.14 in PV of growth
    opportunities –
    • Price = no growth value of the firm + PVGO
    (basically g)
    • P = E1/k + PVGO
    • Now stock prices do NOT always go up when a firm
    cuts dividends! Many times the cut in dividends
    reflects problems with the firm and that
    INFORMATION will cause the stock price to decline.
    • Another factor is that the ROE must be > k for the
    above example to be the case. If ROE = k then the
    stock is a “cash cow”.
    • 
    • Suppose another firm has ROE of 12.5% and k is
    also 12.5%
    • Then g= ROE xb
    • If the firm plows back 60%
    • 
    • g= .125 x .6 = .075
    • 
    • P= 2/(.125-.075) =$40 -- the same as the no growth
    price.
    •TAKE OVER eXAMPLE
    •A firm’s management insists on plowback of 60% in projects
    with ROE of 10%. But the firm’s capitalization rate is 15%. The
    firm pays out $2 on $5 earnings.

    •g = .10 x .6 = .06
    • 
    •P = 2/(.15-.06) = $22.22
    • 
    •PVGO = price per share – no growth value per share
    • = 22.22 – 5/.15 = -11.11
    •
    • So another firm could buy this firm for 22.22 stop
    the plow back and pay out all the earnings
    • 5/.15 = 33.33

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