Problem 18-16 Dividend valuation model and wealth maximization [LO18-2]

Omni Telecom is trying to decide whether to increase its cash dividend immediately or use the funds to increase its future growth rate.

P0	=	D1
		Ke g

P₀ = Price of the stock today D₁ = Dividend at the end of the first year D₁ = D₀ (1 + g) D₀ = Dividend today K_e = Required rate of return g = Constant growth rate in dividends D₀ is currently $2.00, K_e is 8 percent, and g is 4 percent. Under Plan A, D₀ would be immediately increased to $2.50 and K_e and g will remain unchanged. Under Plan B, D₀ will remain at $2.00 but g will go up to 5 percent and K_e will remain unchanged.

a. Compute P₀ (price of the stock today) under Plan A. Note D₁ will be equal to D₀ (1 + g) or $2.50 (1.04). K_e will equal 8 percent, and g will equal 4 percent. (Round your intermediate calculations and final answer to 2 decimal places.)

b. Compute P₀ (price of the stock today) under Plan B. Note D₁ will be equal to D₀ (1 + g) or $2.00 (1.05). K_e will be equal to 8 percent, and g will be equal to 5 percent. (Round your intermediate calculations and final answer to 2 decimal places.)

c. Which plan will produce the higher value?

multiple choice

• Plan A

• Plan B