Part1

Company XYZ's current return on equity (ROE) is 14%. It pays out one half of earnings as cash

dividend (payout ratio = 0.5). Current book value per share is $50. Book value per share will

grow as XYZ reinvests earnings. Assume that the ROE and payout ratio stay constant for the

next four years. After that, competition forces ROE down to 11.5% and payout ratio increases to

0.8. The cost of capital is 11.5%.

a. What are XYZ's EPS and dividends next year? How will EPS and dividends grow in

years 2, 3, 4, 5 and subsequent years? Show your workings.

b. What is XYZ's stock worth per share? How does that value depend on the payout ratio

and growth rate after year 4? Show your workings.

Part 2:

Under what conditions does r, a stock's market capitalisation rate, equal its earnings-price ratio

EPS1/P0?

Part 3:

One of your class mates says that: "You say stock price equals the present value of future

dividends? That's crazy! All the investors I know are looking for capital gains." Respond briefly

to this statement.