A firm issues debt to repurchase equity and at the same time, experiences an increase in its profit margin. All else equal, using the Dividend Discount Model, its stock price ________.
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A. B. C. D.B
Intuitively, it should be clear that the stock price rises since the profit margin has gone up and at the same time, the percentage of equity holders has gone down.
To see this mathematically, note that the duPont system gives ROE = Profit margin * Total Asset Turnover * Financial Leverage. In the present case, the ROE increases since profit margin and Financial Leverage have both increased. The dividend growth rate, g, equals ROE*(1 - payout ratio). Hence, as ROE increases, the dividend growth rate increases with a constant payout ratio. In the Dividend Discount Model, the stock price increases as the dividend growth rate increases, all else equal.