A firm has one million shares outstanding. After-tax earnings have been constant at $10 per share. The firm pays out all earnings in dividends at the end of each year. The shareholders’ required rate of return is 15 percent.
a. Calculate the current share price.
b. The firm considers a one-time retaining of all earnings for the current year. It will revert to a zero retention policy from next year. Assume the new investment promises a return of 10 percent, 15 percent, or 16 percent in perpetuity. Calculate the new share price in each separate case.
c. Is it reasonable for the firm to claim that it would always find enough positive NPV opportunities yielding at least 16 percent, and therefore, it will never pay dividends?