Question

2. Rate of return implied in stock price A corporation has just paid a dividend of $5.00, i.e. D0=$5.00. Due to its growth potential, its dividends are expected to grow at 5% per year starting with the next dividend. If Jerry decides to buy the stock at the current market price $42, what rate of return will he earn?

Answer 1

Answer: 17.5%

Step-by-step explanation:

We can use the Gordon Growth Formula to calculate this.

The formula is as follows,

P = D1 / r – g.

Where D1 is the annual expected dividend of the next year.

P is the current stock value

r is the rate of return and,

g = the expected dividend growth rate which is assumed to be constant.

Because the formula requires that we use the next dividend, we will calculate that first by multiplying the current dividend by the growth rate.

= 5 * (1+0.05)

= $5.25 is the next dividend. Now we have to his we can make the rate the subject of the formula.

r =D1/P+g

Plugging in the figures would be,

=5.25 / 42 + 0.05

= 0.175

= 17.5%

17.5% is therefore the rate of return.

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