19. 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 originally presented in Chapter 10 for purposes of analysis. The model was shown as Formula 10-9 on page 300 and is reproduced below (with a slight addition in definition of terms).

D0 is currently $3.00, is 10 percent, and g is 5 percent.
Under Plan A, D0 would be immediately increased to $3.40 and IQ and g will remain unchanged.
Under Plan B, D0 will remain at $3.00 but g will go up to 6 percent and will remain unchanged.

a. Compute P0 (price of the stock today) under Plan A. Note Dj will be equal to D0 X (1 + g) or $3.40 (1.05). Kg will equal 10 percent and g will equal 5 percent.

b. Compute P0 (price of the stock today) under Plan B. Note Dj will be equal to D0 X (1 + g), or $3.00 (1.06). Kg will be equal to 10 percent and g will be equal to 6 percent.

c. Which plan will produce the higher value?

Transcribed Image Text:

D Ke-g P = Price of the stock today D = Dividend at the end of the first year D = D (1+ g) D = Dividend today K e Required rate of return g= Constant growth rate in dividends