JRN Enterprises just announced that it plans to cut its dividend from $3.50 to $2.50 per share and use the extra funds to expand its operations. Prior to this announcement, JRN's dividends were expected to grow at 3% per year and JRN's stock was trading at $35.00 per share. With the new expansion, JRN's dividends are expected to grow at 7% per year indefinitely. Assuming that JRN's risk is unchanged by the expansion, the value of a share of JRN after the announcement is closest to: a) $79.61. b) $62.05. c) $87.50. d) $41.67.

Answer: d) $41.67

Explanation:

First calculate the cost of capital before the announcement so that the Dividend Discount Model can be used to calculate the new share price.

The Dividend Discount or Gordon Growth Model is,

P = D1 / (r - g)

Where,

P = Price

D1 = Next dividend

r = required rate or risk

g = growth rate

r therefore will be,

r = D1/P + g

Bear in mind that the first dividend increased by 3% every year so the next dividend should have been increased by 3%,

r = (3.50 * 1.03) / 35 + 0.03

r = 13%

Using this risk and assuming it does not change,

The new stock price using the same formula but the new growth rate and dividend will therefore be,

P = D1 / (r - g)

P = 2.5 / (0.13 - 0.07)

P = $41.67

Correct answer is D.