Question
EG Inc. expects to earn $4 per share in year 1. The company has a policy of retaining 60 percent of its ea rnings and
EG Inc. expects to earn $4 per share in year 1. The company has a policy of retaining 60 percent of its earnings and investing them at a return (R) of 20 percent. Stockholders in EG expect a return (K) of 15 percent on the stock.
A financial crisis has hit the US economy requiring EG to sharply alter its strategy for the coming years. The company needs to conserve cash; consequently it decides to retain 90 percent of its earnings. Because of reduced investment opportunities, the retained earnings can only be reinvested at a sharply reduced rate (R) of 5 percent per year. This new strategy will be pursued for the next 3 years. After 3 years EG will revert to its old strategy of retaining 60 percent of earnings and investing them at 20 percent per year. In addition, the market has sharply increased the risk premium on all stocks. This results in EGs new required rate of return (K) to rise to 20 percent. Given this new information:
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