Question

A firm is expected to pay a dividend of $10 next year and afterwards dividends are expected to grow at 3% per annum in perpetuity. Assume the firm's required rate of return is 5%. 

a. What should be its stock price?

b. A second firm that is expected to pay also a dividend of $10 next year has the same stock price as the first. However, after analyzing the financial statements of this second firm you realize that its dividends are likely to grow only at 2% per annum in perpetuity. If both firms are correctly priced what should be the second firm's required rate of return?

Answer 1

a)

Stock price = D1 / (Ke - g)

where D1 = next year dividend

K = required return

g = growth rate

Stock price = 10 / (5% - 3%)

= $500

b)

using the same formula as above

500 = 10 / (K - 2%)

K = (10 / 500) + 2%

K = 4%

Required return = 4%