Question
Crane Sporting Goods expects to have earnings per share of $10 in the coming year. Rather than reinvest these earnings and grow, the firm plans
Crane Sporting Goods expects to have earnings per share of $10 in the coming year. Rather than reinvest these earnings and grow, the firm plans to pay out all of its earnings as a dividend. With these expectations of no growth, Crane's current share price is $100 and the cost of equity capital is 10%.
Suppose Crane could cut its divident payout rate to 50% for the foreseeable future and use the retained earnings to open new stores. The return on investment in these stores is expected to be 8%. if we assume that the risk of these new investments is the same as the risk of its existing investments, then the firm's equity cost of capital is unchanged. What effect would this new policy have on Crane's stock price?
A. | Does not change. | |
B. | Decrease because retention rate increase to 50%. | |
C. | Decrease because return on new investment is lower than the cost of equity capital. | |
D. | Increase because dividend payout rate drops to 50%. |
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