Question 7.4: Suppose Crane Sporting Goods decides to cut its dividend pay...
Suppose Crane Sporting Goods decides to cut its dividend payout rate to 75% to invest in new stores, as in Example 7.3. But now suppose that the return on these new investments is 8%, rather than 12%. Given its expected earnings per share this year of $6 and its equity cost of capital of 10% (we again assume that the risk of the new investments is the same as its existing investments), what will happen to Crane’s current share price in this case?
Plan
We will follow the steps in Example 7.3, except that in this case, we assume a return on new investments of 8% when computing the new growth rate 1 g2 instead of 12% as in Example 7.3
Execute
Just as in Example 7.3, Crane’s dividend will fall to $6 × 0.75 = $4.50. Its growth rate under the new policy, given the lower return on new investment, will now be g = 0.25 × 0.08 = 0.02 = 2%. The new share price is therefore
P_{0}=\frac{Div_{1}}{r_{E}-g} =\frac{\$4.50}{0.10-0.02} =\$56.25Evaluate
Even though Crane will grow under the new policy, the return on its new investments is too low. The company’s share price will fall if it cuts its dividend to make new investments with a return of only 8%. By reinvesting its earnings at a rate (8%) that is lower than its equity cost of capital (10%), Crane has reduced shareholder value.