Question

7-7 Common stock value-Zero growth Kelsey Drums, Inc., is a well-established supplier of fine percussion instruments to orchestras all over the United States. The company's class A common stock has paid a dividend of $5.00 per share per year for the last 15 years. Management expects to continue to pay at that rate for the foreseeable future. Sally Talbot purchased 100 shares of Kelsey class A common 10 years ago at a time when the required rate of return for the stock was 16%. She wants to sell her shares today. The current required rate of return for the stock is 12%. How much capital gain or loss will she have on her shares?

Answer 1

Sally Talbot will have a capital gain, as her shares' selling price at a 12% required return is higher than her purchase price at a 16% required return. Each share will net a $10.42 gain, amounting to a total gain of $1042 for 100 shares.

The value of a common stock with zero growth can be calculated by taking the annual dividend and dividing it by the required rate of return.

Given that Kelsey Drums' stock has a consistent dividend of $5.00, originally bought at a 16% required rate of return, the purchase price was $31.25 (5 / 0.16).

Now with a required rate of return of 12%, the selling price is $41.67 (5 / 0.12). If Sally Talbot sells her shares at the current value, she will experience a capital gain since the selling price will be higher than her purchase price.

To calculate capital gains, we use the following formula:

Capital Gain/Loss = Selling Price - Purchase Price.

Sally's capital gain per share = $41.67 - $31.25 = $10.42.

Total capital gain for 100 shares = 100 * $10.42 = $1042.