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Question - DFB, Inc., expects earnings by the end of the year to be $5 per share, and it plans to pay a $3 dividend to shareholders. DFB will retain $2 per share of its earnings to reinvest in new projects with an expected return of 15% per year. The dividend payout rate and return on new investments will remain constant for the first 5 years. After that, the payout ratio will be increased to 80% and the return on new investments will drop to 10%. Assume that the number of outstanding shares remains constant over time.
(a) What is the growth rate of earnings for DFB in the first 5 years? And what is the growth rate after the first 5 years?
(b) If DFB's equity cost of capital is 12%, what price would you estimate for DFB stock?
(c) Assume that the projects' profitability does not change if you undertake more or less projects. What would be the optimal payout ratio in the first five years and after? What would be the price of DFB stock in that case?
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