Problem

Today is January 2nd 2017 and a construction company named LewCo pays an annual dividend on the last day of each year and has a current price of $50 per share. The most recent dividend was $3 per share and the dividend has grown by 5% per year since the company was started in 1958.

A. What expected return (discount rate, cost of capital) are investors attaching to LewCo based on the dividend discount model?

B. LewCo announces that recent housing crash and subsequent regulatory changes has reduced demand for their construction projects, resulting in a change to their earnings outlook and dividend policy. They announce that they plan to hold their dividend constant at $3 per year for the foreseeable future. What do you predict will be the new share price assuming the cost of capital as in part (a)?

C. An investor invests $1000 in LewCo on January 2, 2017 when the price was $50 per share. They liquidate the investment a year later, (January 2018) after receiving the dividend payment, at a sale price of $49. How many dollars of profit did they earn and what was the annualized percent of total return?

D. NewCo, a competitor of LewCo, has never paid a dividend. The NewCo board of directors is discussing whether they should pay a dividend or continue with their current policy. Name and explain two of the different theories discussed in class for why a company should or should not pay a dividend.