1.

Example of dividend decrease and price

decrease.
2. Takeover example
 
• Inputs -- plant and equipment = 100 million all
equity financed.
• ROE = 15%
• ROE = .15 * 100 million = 15 million.
• If there are 3 million shares outstanding
this represents $5 per share in earnings.
• Capitalization rate (required return) = 12.5%
• If 60% of the 15 million is reinvested then this
represents $9 million increase in the firm’s capital.
• g = ROE xb = .15 x .6 = .09
• P= D1/(k-g)  Now if 60% is retained then 40% is
paid out so dividends are now $2.
• 
• P= 2/(.125-.09) = 57.14
• The no retention ( plowback) price is P = 5/.12.5 =
$40
• 
• There the price reflects $ 17.14 in PV of growth
opportunities –
• Price = no growth value of the firm + PVGO
(basically g)
• P = E1/k + PVGO
• Now stock prices do NOT always go up when a firm
cuts dividends! Many times the cut in dividends
reflects problems with the firm and that
INFORMATION will cause the stock price to decline.
• Another factor is that the ROE must be > k for the
above example to be the case. If ROE = k then the
stock is a “cash cow”.
• 
• Suppose another firm has ROE of 12.5% and k is
also 12.5%
• Then g= ROE xb
• If the firm plows back 60%
• 
• g= .125 x .6 = .075
• 
• P= 2/(.125-.075) =$40 -- the same as the no growth
price.
•TAKE OVER eXAMPLE
•A firm’s management insists on plowback of 60% in projects
with ROE of 10%. But the firm’s capitalization rate is 15%. The
firm pays out $2 on $5 earnings.

•g = .10 x .6 = .06
• 
•P = 2/(.15-.06) = $22.22
• 
•PVGO = price per share – no growth value per share
• = 22.22 – 5/.15 = -11.11
•
• So another firm could buy this firm for 22.22 stop
the plow back and pay out all the earnings
• 5/.15 = 33.33