Question

The stock of Nogro Corporation is currently selling for $20 per share. Earnings per share in the coming year are expected to be $3. The company has a policy of paying out 40% of its earnings each year in dividends. The rest is retained and invested in projects that earn a 15% rate of return per year. This situation is expected to continue indefinitely. a. Assuming the current market price of the stock reflects its intrinsic value as computed using the constant-growth DDM, what rate of return do Nogro’s investors require? (Do not round intermediate calculations.)

Answer 1

Answer: Required return = 15%

Explanation:

Current Price using the constant-growth DDM is;

Current Price = Expected dividend / ( Required return - growth rate)

This can therefore be used to calculate the required return.

Growth rate = Return on Equity * Retention ratio

= 15% *  ( 1 - payout ratio )

=  15% * (1 - 40%)

= 15% * 60%

= 9%

Expected dividend = Earnings per share * Payout ratio

= 3 * 40%

= $1.20

Using the formula;

Current Price = Expected dividend / ( Required return - growth rate)

20 = 1.20 / (Required return - 9%)

20 *  (Required return - 9%) = 1.20

Required return - 9% = 1.20 / 20

Required return = (1.20 / 20) + 9%

Required return = 15%