Question

Consider a stock which just paid a dividend of $2.50. If the firm expects earnings and dividends to grow at a rate of 4%, what price would you pay for the stock if you require a rate of return equal to 9%?

Answer 1

Using the Dividend Discount Model, with a $2.50 dividend, 4% growth, and a 9% required rate of return, you would pay $52.00 for the stock.

Step-by-step explanation:

To determine the price you would pay for the stock mentioned, given a dividend of $2.50, an expected growth rate of 4%, and a required rate of return of 9%, you can use the Gordon Growth Model (also known as the Dividend Discount Model). The formula is P = D / (r - g), where P is the price of the stock, D is the dividend, r is the required rate of return, and g is the growth rate.

In this case, the dividend next year (D1) would be $2.50 multiplied by 1.04 (to account for growth), so D1 = $2.60. Then you plug the values into the formula: P = $2.60 / (0.09 - 0.04) which equals $52.00. Therefore, based on the required rate of return, you would be willing to pay $52.00 for the stock.