Question

Assume ABC Corporation is expected to pay a dividend in the amount of $3 and the dividend is expected to grow at a constant rate of 5 percent. What is the expected rate if the stock is currently trading at $50 a share? What is the dividend yield? What is the capital gain rate?

Answer 1

a)

Let dividend at the end of Year 1 be   , growth rate be and expected rate be  

Using Constant Growth formulae,

Therefore,

Therefore the expected return on the stock is 11%

b)

Therefore Dividend Yield is 6%

c)

In order to calculate the capital gain rate, let us first calculate the expected price of the stock after 1 year.

The dividend for the 2nd year is expected to be $3 + 5%

ie $3.15

(we have already calculated R_e as 11%)

(same as dividend growth rate)

Please note that in a constant growth model, the stock price always grows at the rate equal to dividend growth.