Question

Two chemical corporations, both equity financed with no debt, are essentially in the same business. However, whereas one of the corporations has a stable earnings and dividend record, paying out all its earnings in dividends, the other is a growth stock increasing its earnings and dividends annually through a different management strategy. The current dividend is $5 per share for both corporations. The stable corporation's stock trades for $40 per share and the price of the growth stock is $50.Estimate the investors' required rate of return on these stocks and the steady future growth rate of the growing corporation as perceived by the market.

if someone can do this and show me how its done i would greatly appreciate it.

Answer 1

current dividend $5

price of stable corporation $40

price of growth stock $50

in order to calculate the price of stocks we use the perpetuity or perpetuity with growth formula:

• perpetuity formula ⇒ stock price = dividend / required rate of return
• perpetuity with growth ⇒ stock price = dividend / (required rate of return - growth rate)

the investors' required rate of return for the stable corporation:

$40 = $5 / rrr

rrr = $5 / $40 = 12.5%

what changes with the growth corporation is not the rrr, it is the growth rate that decreases it:

$50 = $5 / (rrr - g) = $5 / (0.125 - g)

0.125 - g = $5 / $50

0.125 - g = 0.1

g = 0.125 - 0.1 = 0.025 or 2.5%