Question

You are considering the purchase of a stock that is currently selling at $ 64 per share. You expect the stock to pay $ 4.50 in dividends next year. a.If dividends are expected to grow at a constant rate of 3 percent per year, what is your expected rate of return on this stock? b.If dividends are expected to grow at a constant rate of 5 percent per year, what is your expected rate of return on this stock?

Answer 1

Answer:

a. Expected rate of return = 10%

b. Expected rate of return = 12%

Explanation:

Using dividend growth model we have,

$P_0 = \frac{D_1}{K_e - g}$

where P$_0$ = Current market price

D$_1$ = Dividend at the year end

K$_e$ = Expected return

g = growth rate

Putting values in the above we have,

a. $64 = $\frac{4.5}{K_e - 0.03}$

$K_e - 0.03$ = $\frac{4.5}{64} = 0.07$

K$_e$ = 0.07 + 0.03 = 0.1 = 10%

b. $64 = $\frac{4.5}{K_e - 0.05}$

$K_e - 0.05$ = $\frac{4.5}{64} = 0.07$

K$_e$ = 0.07 + 0.05 = 0.12 = 12%

Final Answer

a. Expected rate of return = 10%

b. Expected rate of return = 12%