Chapter 16, Problem 17PS

Repurchases and the DCF model* Surf & Turf Hotels is a mature business, although it pays no cash dividends. Next year’s earnings are forecasted at $56 million. There are 10 million outstanding shares. The company has traditionally paid out 50% of earnings by repurchases and reinvested the remaining earnings. With reinvestment, the company has generated steady growth averaging 5% per year. Assume the cost of equity is 12%.

1. a. Calculate Surf & Turf’s current stock price, using the constant-growth DCF model from Chapter 4. (Hint: Take the easy route and estimate overall market capitalization.)
2. b. Now Surf & Turf’s CFO announces a switch from repurchases to a regular cash dividend. Next year’s dividend will be $2.80 per share. The CFO reassures investors that the company will continue to pay out 50% of earnings and reinvest 50%. All future payouts will come as dividends, however. What would you expect to happen to Surf & Turf’s stock price? Why?