DFB, Inc., expects earnings this year of $5.37 per share, and it plans to pay a $3.54 dividend to shareholders. DFB will retain $1.83 per share of its earnings to reinvest in new projects with an expected return of 15.3% per year. Suppose DFB will maintain the same dividend payout rate, retention rate, and return on new investments in the future and will not change its number of outstanding shares.
a. What growth rate of earnings would you forecast for DFB?
b. If DFB's equity cost of capital is 11.9%, what price would you estimate for DFB stock?
c. Suppose DFB instead paid a dividend of $4.54 per share this year and retained only $0.83 per share in earnings. That is, it chose to pay a higher dividend instead of reinvesting in as many new projects. If DFB maintains this higher payout rate in the future, what stock price would you estimate now? Should DFB follow this new policy?
This is what the company should do:___________
A. Raise dividends because the return on new investments is lower than the cost of capital.
B. Not raise dividends because projects have positive NPV when the return on new investments is higher than the firm's cost of capital.
C. Raise dividends because, according to the dividend-discount model, doing so will always improve the share price.
D. Not raise dividends because companies should always reinvest as much as possible.