Question

Eastern Electric expects to pay a dividend of $1.69 per share next year and sells for $24 a share. a. If investors believe the growth rate of dividends is 2% per year, what rate of return (r) do they expect to earn on the stock? b. Instead of the facts outlined in a. above, if investors' required rate of return is now 12%, what must be the growth rate they expect of the firm (based on the initial facts provided)? c. At a sustainable growth rate of 3% and a plowback ratio of 30%, what must be the rate of return earned by the firm on its new investments?

Answer 1

Answer:

a. 9.04%

b. 4.96% approx.

c. 10%

Explanation:

a. As per dividend growth model,

Required rate of return = $\frac{D_{1} }{P_{0} } \ +\ g$

wherein, $D_{1}$ = Next year expected dividend

               $P_{0}$ =  Current market price of a share as on today

               g = Annual growth rate in dividend ( in percentage)

               r = Rate of return or cost of equity

Hence, required rate of return (r) = $\frac{1.69}{24} \ +\ .02$   = 9.04%

b.  R = 12%

    $P_{0}$ = $24

    $D_{1}$ = $1.69

Then, using the above formula, we have,

.12 = $\frac{1.69}{24} \ +\ g$

⇒ g = 4.96 % approx

c. g = 3%

   Retention ratio (b) = 30%

   Hence dividend payout ratio = 1 - 30 = 70%

   g = b × r

   .03 = .3 × r

⇒ r = 0.1 or 10%

Hence, rate of return earned by the firm on its's new investment is 10%.