You Are Considering the Stock of Two Firms to Add

Essay

You are considering the stock of two firms to add to your portfolio. The companies differ only with respect to their dividend policies. For both firms, investors expect EPS for each of the next two years to be $7 and dividends and ending price for each of the next two periods to be:
D1 D2 P2
Firm A $2 $2 $60.70
Firm B 4 4 56.42
The required rate of return for the stock of Firm A is 14%. Ignore taxes or transaction fees.
a. How much would investors pay for the stock of Firm A?
b. How much would investors pay for the stock of Firm B?
c. For a less-than-perfect world, provide an argument for each of the following:
(1) Investors prefer the dividend policy of Firm A.
(2) Investors prefer the dividend policy of Firm B.
(3) Firms prefer the dividend policy of Firm A.