Question

ACE has EPS of $10.00 per share and has a retention ratio of 80%. Its dividend is expected to grow at a rate of 9%. If ACE stock is trading at $54.50, then the shareholder's required return is closest to:

• A. 4%.
• B. 9%.
• C. 11%.
• D. 13%.

Answer 1

EPS ( earnings Per Share ) = $10

Retention Ratio = 80% or 0.80

So, Payout Ratio = 1 – Retention Ratio

= 1 – 0.80

= 0.20

So, Current Dividend ( D0 ) = $10 x 0.20

= $2

Dividend Growth rate ( G ) = 9% or 0.09

Now, Price of a constant growth dividend stock is given by

Price = D1 / ( Re – G )

Where,

D1 = Expected Dividend next year

= Current Dividend x ( 1 + Growth rate )

= $2 x 1.09

= $2.18

Re = Required rate of return

Price = $54.50

So, putting the values in above equation we get,

$54.50 = $2.18 / ( Re – 0.09 )

So, Re – 0.09 = $2.18 / $54.50

So, Re = 0.04 + 0.09

= 0.13 or 13%

So, the required rate of return is 13% and so option D is the correct option