Assuming that the constant growth rate dividend discount model can be applied, work out the rate at which the dividends of the following firm is expected to grow:
(a). XYZ Inc. pays out 40% of its earnings as dividends, has a “historical” P/E ratio [current price to trailing twelve months’ earnings] of 4, and a market capitalization rate of 10% per year.
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The question gives the percentage of earnings given out as dividends, which is 40%; the historical P/E ratio, which is 4; and the market capitalization rate of 10% per year.
The market capitalization rate is equal to the yearly income divided by the total investment made. Here, the yearly income is the dividend that is paid by the company. If the value of the stock of company XYZ is P, D/P = 10% or the dividend is 10% the value of the stock. The price by earning ratio is 4. The percentage of the earnings of the company given out as dividend is 40%. This gives: D/P = 10%, P/E = 4 and D/E = 40%.
From the information provided it is not possible to determine the rate at which dividends are expected to grow. The information is insufficient.
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