Problem 5. The dividend growth model is used by many investors to value stock. Using the dividend-payout ratio, and the sustainable growth rate equation in the dividend growth model, calculate the price of a share of stock today, using the following dividend growth model equation. Then use your results to explain whether the firm should pay a dividend or expand its manufacturing capability.

The dividend-payout ratio is one minus b, where b is the retention ratio; the dividend next year will be the earnings next year, E1, times one, minus the retention ratio: P0 = E1(1b).

The sustainable growth rate is the return on equity times the retention ratio: Rs ROE x b. The dividend growth model equation for calculating the price of a share of stock today is:

P0 = E1(1b) /Rs ROE x b