Question

Eastern Electric currently pays a dividend of $1.69 per share and sells for $24 a share.

If investors believe the growth rate of dividends is 2% per year, what rate of return do they expect to earn on the stock?

Answer 1

Investors expect to earn a 9.1825% return on Eastern Electric's stock by using the Gordon growth model with the given dividend payment of $1.69 per share, the $24 share price, and an expected dividend growth rate of 2%.

Step-by-step explanation:

To calculate the expected rate of return on Eastern Electric’s stock, given its current dividend and price per share, along with the expected dividend growth rate, we can use the Gordon growth model (also known as the dividend discount model).

1. Current dividend per share (D0): $1.69.
2. Expected dividend growth rate (g): 2% or 0.02 in decimal form.
3. Current stock price (P0): $24.
4. The formula for the expected rate of return using the Gordon growth model is:

Expected Rate of Return (r) = (D0 × (1 + g)) / P0 + g

1. Plug in the values:

r = ($1.69 × (1 + 0.02)) / $24 + 0.02

1. Simplify and solve for the expected rate of return:

r = ($1.69 × 1.02) / $24 + 0.02
r = $1.7238 / $24 + 0.02
r = 0.071825 + 0.02
r = 0.091825 or 9.1825%

Therefore, investors expect to earn a 9.1825% return on Eastern Electric’s stock.