A fairly priced unlevered firm plans to pay a dividend of $2 next year (t=1) which is expected to grow by 5% pa every year after that. The firm's required return on equity is 12% pa. The firm is thinking about reducing its future dividend payments by 10% so that it can use the extra cash to invest in more projects which are expected to return 12% p.a., and have the same risk as the existing projects. Therefore, next year's dividend will be $1.80. What will be the stock's new annual capital return (proportional increase in price per year) if the change in payout policy goes ahead? Assume that payout policy is irrelevant to firm value and that all rates are effective annual rates.

Answer rating: 100% (QA)

To calculate the new annual capital return we need to consider the Gordon Growth Model which calcula... View the full answer