FM – L2 – Q33 – Dividend policy

Suggest share price for Kumasi Transport PLC based on 25% dividend payout using dividend growth model.

Question

he directors of an all-equity company are considering the company’s policy on dividends and retentions. The cost of capital is 9% and the company is able to invest in new capital projects that will earn this return. The company’s shares are quoted and traded on a major stock market.

In the year just ended, the earnings per share were GH¢2.00 per share. The company pays a dividend annually, and is about to pay a dividend for the year just ended on the basis of its selected dividend and retentions policy.

Required:

Suggest what the company’s share price might be if the directors select a policy of paying annual dividends that are equal to:

(a) 25% of earnings

(b) 50% of earnings

Answer

(A). Dividends are 25% of earnings and 75% of earnings are retained:

Growth rate = 0.75 × 0.09 = 0.0675.

Expected share price = 0.50(1.0675) / (0.09 – 0.0675) = GH¢23.72

(B). Dividends are 50% of earnings and 50% of earnings are retained:

Growth rate = 0.50 × 0.09 = 0.045.

Expected share price = 1.00(1.045) / (0.09 – 0.045) = GH¢23.22

(C). Dividends are 70% of earnings and 30% of earnings are retained:

Growth rate = 0.30 × 0.09 = 0.027.

Expected share price = 1.40(1.027) / (0.09 – 0.027) = GH¢22.82

Tags: Dividend Growth Model, Dividend Policy, Earnings retention, Equity financing, Share price valuation
Level: Level 2

Topic: Dividend policy

Uploader: Samuel Duah