West-Coast Business Software (WBS) just reported $24 million total net income. The firm has 10 million shares outstanding. Analysts expect that WBS can sustain a long-run return on reinvestment (RIR) of 15%. The firm’s cost of capital is 12%. a. What are the firm’s earnings per share (EPS)? Suppose WBS pays a dividend of $1.60 per share. What is the pay-out ratio? b. Given the pay-out ratio calculated in part a), what is the expected rate of dividend growth? What is the value of the firm’s stock? c. How would the answer to part b) change if WBS instead followed a policy of paying only 1/3 of earnings as dividends?

Earning per share can be calculated by dividing the total net income a company in the total number of shares the company has issued. After finding EPS we can calculatate payout ratio easily by dividing dividends per share in Earning per share.

DATA

Net income = 24m

No of shares = 10m

RIR = 15%

Ke = 12%

a)

EPS = Net Income / No. of share outstanding

EPS = $24,000,000 / 10,000,000 shares

EPS = $2.40 per share

Pay-out ratio = Dividend per share / Earning per share

Pay-out ratio = $1.60 / $2.40

Pay-out ratio = 2 / 3

b)

Growth rate = (1 - payout ratio) x RIR

Growth rate= (1 - 2/3) x 15%

Growth rate = 5%

Price of a stock (P0) = D0 x (1 + g) / (Ke - g)

Where do KE = cost of capital , g = growth

Price of a stock (P0) = $1.60 x (1 + 0.05) / (0.12 - 0.05)

Price of a stock (P0) = $1.68 / 0.07

Price of a stock (P0) = $24

c) If the payout ratio was 1/3,

Growth rate = (1 - 1/3) x 15%

Growth rate = 2/3 x 15%

Growth rate = 10%

Dividend per share (D0) = $2.4 x 1/3

Dividend per share (D0) = $0.80 per share

P0 = $0.80 x (1 + 0.10) / (0.12 - 0.10)

P0= $0.88 / 0.02

P0= $44