Question

a. Computer stocks currently provide an expected rate of return of 16%. MBI, a large computer company, will pay a year-end dividend of \(2 per share. If the stock is selling at \)50 per share, what must be the market’s expectation of the growth rate of MBI dividends?

b. If dividend growth forecasts for MBI are revised downward to 5% per year, what will happen to the price of MBI stock? What (qualitatively) will happen to the company’s price–earnings ratio?.

Short answer

a. 12%

b. $18.18, low growth forecast of firm

Step-by-step solution

Step by Step Solution Step 1: Given information

P₀ = $50

D₁= $2

k = 16%

Calculation of Expected growth rate of dividends ‘a’

Using constant growth DDM, P₀= D₁/ k – g

$50 = $2 / 0.16 – g

g = 0.12 or 12%

Calculation of Price and price-earnings ratio ‘b’

P₀= D₁/ k – g

= $2 / 0.16 – 0.05 (given)

= $18.18

This implies that despite the fall in price, the forecast of current earnings is unchanged. P/E ratio therefore decreases which is an evidence of low optimism about firm’s growth forecasts.