Question

1. A stock just paid a dividend of D₀ = $0.66. Dividend is expected to grow at a constant rate of 3.2%. The required rate of return is 15.7%. What is the current stock price?

2. XYZ stock is currently selling for $40.35 per share. The company just paid its first annual dividend of $4.08 a share. The firm plans to increase the dividend by 7 percent per year indefinitely. What is the expected return on XYZ stock?

Answer 1

Solution to PART-1

Here, we have Dividend per share in year 0 (D0) = $0.66 per share

Dividend Growth Rate (g) = 3.20% per year

Required Rate of Return (Ke) = 15.70%

As per Constant Growth Dividend Valuation Model, the Value of the stock is calculated as follows

Current Value of the stock = D0(1 + g) / (Ke – g)

= $0.66(1 + 0.020) / (0.1570 – 0.0320)

= $0.68112 / 0.1250

= $5.45 per share

“Hence, the current stock price will be $5.45”

Solution to PART-2

Here, we’ve Dividend per share for the current year (D0) = $4.085 per share

Current Share Price (P0) = $40.35 per share

Dividend Growth Rate (g) = 7.00% per year

Dividend per share for the next year (D1)

Dividend per share for the next year (D1) = D0 x (1 + g)

= $4.08 x (1 + 0.07)

= $4.08 x 1.07

= $4.3656 per share

Therefore, the Expected Return on the Stock = (D1 / P0) + g

= [$4.3656 / $40.35] + 0.07

= 0.1082 + 0.07

= 0.1782 or

= 17.82%

“Hence, the expected return on XYZ stock will be 17.82%”