Reference no: EM132751301

A fairly priced unlevered firm plans to pay a dividend of $9 next year (t=1) which is expected to grow by 2.5% pa every year after that forever. This dividend growth rate is the stock's capital return. The firm's required return on equity is 10% pa. The firm can be valued using the dividend discount model.

• The firm is thinking about decreasing its future dividend payments by 25% to finance more zero-NPV research and development projects which are expected to return 10% pa, and have the same risk as the existing projects. Therefore, next year's dividend will be $6.75.

Problem 1: What will be the stock's new expected future capital return per annum (proportional increase in price per year) if the change in payout policy goes ahead? Assume that payout policy is irrelevant to firm value and that all rates are effective annual rates. The new expected capital return will be:

Select one:

a. 1.875% pa
b. 2.5% pa
c. 3.125% pa
d. 4.375% pa
e. 4.8125% pa