Question

The common stock of Eddie's Engines, Inc., sells for $38.03 a share. The stock is expected to pay a dividend of $4.00 per share next year. Eddie's has established a pattern of increasing their dividends by 6.1 percent annually and expects to continue doing so. What is the market rate of return on this stock?

Answer 1

The required rate of return on this stock is 16.62%

Step-by-step explanation:

The market price of a stock whose dividend growth rate is constant can be calculated using the constant growth model of the dividend discount model approach. It values a stock based on the present value of the expected future dividend from the stock. The present value is calculated using the required rate of return on the stock. The formula for price today under this model is,

P0 = D1 / (r - g)

Where,

• D1 is the dividend for the next period
• r is the required rate of return
• g is the growth rate in dividends

As we know the current market price, the dividend for the next period and the growth rate in dividends, by plugging in these values in the formula, we calculate the required rate of return to be:

38.03 = 4 / (r - 0.061)

38.03 * (r - 0.061) = 4

38.03r - 2.31983 = 4

38.03r = 4 + 2.31983

r = 6.31983 / 38.03

r = 0.16618 or 16.618% rounded off to 16.62%