It’s early morning on January 1st, 2008 and Mr Duby is thinking about investing in ABC stocks. ABC reported earnings per share (EPS) of $2 as of…

It’s early morning on January 1st, 2008 and Mr Duby is thinking about investing in ABC stocks. ABC reported earnings per share (EPS) of $2 as of December 31, 2007 but paid no dividends. Earnings are expected to grow at 16% per year for the following 4 years. ABC will start paying dividends for the first time on December 31, 2011, distributing 40% of its earnings to shareholders. Earnings growth will slow to 7.5% per year for the next 5 years (i.e. from January 1, 2012 through December 31, 2016). Starting December 31, 2016 ABC will pay out 70% of its earnings in dividends and earnings growth will stabilize at 2% per year forever. The required rate of return on ABC stock is 10%.

a.     How much should Mr. Pitt pay for a share of ABC stock given the above earnings and dividend forecast?

b.     What would be the value of the stock today if Mr Duby could convince ABC directors to change the company’s future dividend policy to pay out 100% of its December 31, 2016 earnings in dividends (i.e. the retention ratio would become 0%) and maintain this dividend policy forever? In other words, starting on December 31, 2016, should the company pay out all of its earnings in dividends instead of pursuing their growth strategy?

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