The management of firm XYZ tends to pay out 35% of its earnings in dividends each year, while the remainder is retained for capital investments that provide an expected ROE of 18%.If the firm's cost of equity capital is 13% and next year's expected dividend is D_t=$0.50 per share, compute the value of the firm's shares using the constant dividend growth model as interpreted through the sustainable growth model.

Question

Quizplus · Accepted Answer

The correct answer is A because the constant dividend growth model, as interpreted through the sustainable growth model, values a firm's shares as the present value of all future dividends. The formula for this model is:P0 = D1 / (r - g)where:P0 is the current share priceD1 is the next year's expected dividendr is the cost of equity capitalg is the sustainable growth rateIn this case, the next year's expected dividend is $0.50 per share, the cost of equity capital is 13%, and the sustainable growth rate is 18%. Plugging these values into the formula, we get:P0 = $0.50 / (0.13 - 0.18) = $7.46

The Management of Firm XYZ Tends to Pay Out 35