Question

You believe that the Non-stick Gum Factory will pay a dividend of $1 on its common stock next year. Thereafter, you expect dividends to grow at a rate of 4% a year in perpetuity. If you require a return of 8% on your investment, how much should you be prepared to pay for the stock? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Answer 1

The share price of the stock=$25

Step-by-step explanation:

Derive the expression for calculating the required rate of return as follows:

RRR=(EDP/SP)+DGW

where;

RRR=required rate of return

EDP=expected dividend payment

SP=share price

DGW=dividend growth rate

In our case:

RRR=8%=8/100=0.08

EDP=$1

SP=unknown

DGW=4%=4/100=0.04

replacing in the original expression;

0.08=(1/SP)+0.04

1/SP=0.08-0.04

1/SP=0.04

SP=1/0.04=25

The share price of the stock=$25