Question

A firm pays a current dividend of $1 which is expected to grow at a rate of 5% indefinitely. If current value of the firm’s shares is $35, what is the required return applicable to the investment based on the constant-growth dividend discount model (DDM)?

Answer 1

8%

Step-by-step explanation:

We know that

Value of stock = Next year dividend ÷ (Required rate of return - growth rate)

where,

Next year dividend would be

= $1 + $1× 5%

= $1 + 0.05

= $1.05

The other items rate would remain same

Now put these values to the above formula

So, the value would equal to

$35 = $1.05 ÷ (Required rate of return - 5%)

(Required rate of return - 5%) = $1.05 ÷ $35

(Required rate of return - 5%) = 3%

So, the required rate of return would be

= 3% + 5%

= 8%