The Phoenix (P) Corp. is operating in an essential business that its local council is sponsoring. To induce P Corp to remain in this essential business, the council has agreed to pay whatever amount is necessary to yield P Corp a 10% book return on equity. At the end of the year, P Corp is expected to pay a $5 dividend. It has been reinvesting 30% of earnings.

Q:

1. Suppose P Corp continues on this growth trend. What is the expected long-run rate of return from purchasing the stock at $100? What part of the $100 price is attributable to the present value of growth opportunities?

2. Now the council announces a plan for P Corp. P Corp will, therefore, be expanded gradually over two years. This means that P Corp will have to reinvest 70% of its earnings for two years. Starting in year 3, however, it will again be able to pay out 70% of earnings. What will be P Corp's stock price once this announcement is made and its consequences for P Corp. are known?