Question

year was $2.78 and is expected to be $3 at the end of this year, the current stock price is $60, and the growth rate for dividends is 8 percent. Using the Gordon approach, what is the expected return?

Answer 1

Answer:

The expected return is 13%.

Explanation:

Note: Before answering the question, the full question is first stated as follows:

A firm's stock cash dividend per share for last year was $2.78 and is expected to be $3 at the end of this year, the current stock price is $60, and the growth rate for dividends is 8 percent. Using the Gordon approach, what is the expected return?

The answer to the explanation of the answer is now as follows:

Gordon’s theory which is also known as ‘Bird-in-the-hand’ theory states that the importing factor to consider in determining the value of a firm are the current dividends.

Therefore, the Gordon growth model (GGM) formula which assumes that there will a stable dividend growth rate year after year forever is employed for this question as follows:

P = d1 / (r – g) ……………………………………… (1)

Where;

P = current stock price = $60

d1 = next dividend = $3

r = expected return = ?

g = growth rate of dividend = 8%, or 0.08

Substituting the values into equation (1) and solve for r, we have:

60 = 3 / (r - 0.08)

60(r - 0.08) = 3

60r - 4.80 = 3

60r = 3 + 4.80

r = 7.80 / 60

r = 0.13, or 13%

Therefore, the expected return is 13%.