Problem 11-09

The dividend-growth model suggests that an increase in the dividend growth rate will increase the value of a stock. However, an increase in the growth may require an increase in retained earnings and a reduction in the current dividend. Thus, management may be faced with a dilemma: current dividends versus future growth. As of now, investors required return is 10 percent. The current dividend is $1.5 a share and is expected to grow annually by 5 percent, so the current market price of the stock is $31.5. Management may make an investment that will increase the firms growth rate to 7 percent, but the investment will require an increase in retained earnings, so the firms dividend must be cut to $1 a share. Should management make the investment and reduce the dividend? Round your answer to the nearest cent.

The value of the stock rises to $_________, so the management should make the investment and decrease the dividend.