Question

Eastern Electric currently pays a dividend of about $1.64 per share and sells for $27 a share.

a. If investors believe the growth rate of dividends is 3% per year, what rate of return do they expect to earn on the stock? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

b. If investors' required rate of return is 10%, what must be the growth rate they expect of the firm? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

c. If the sustainable growth rate is 5% and the plowback ratio is .4, what must be the rate of return earned by the firm on its new investments? (Enter your answer as a percent rounded to 2 decimal places.)

Answer 1

Requirement (a) – Rate of Return

As per Dividend Discount Model, the Required Rate of Return is calculated as follows

Required Rate of Return = [D0(1 + g) / P0] + g

Where, Last year Dividend (D0) = $1.64 per share

Dividend Growth Rate (g) = 3% per year

Current Share Price (P0) = $27.00 per share

Therefore, the Required Rate of Return = [D0(1 + g) / P0] + g

= [D0(1 + g) / P0] + g

= [$1.64(1 + 0.03) / 27.00] + 0.03

= [$1.6892 / $27.00] + 0.03

= 0.0626 + 0.03

= 0.0926 or

= 9.26%

“Rate of Return = 9.26%”

Requirement (b) – Growth Rate expected by the firm

Required Rate of Return = 10%

Where, Last year Dividend (D0) = $1.64 per share

Current Share Price (P0) = $27.00 per share

Required Rate of Return = [D0(1 + g) / P0] + g

0.10 = [$1.64(1 + g) / $27.00] + g

0.10 – g = $1.64(1 + g) / $27.00

$2.70 – 27g = $1.64 + 1.64g

$1.06 = 28.64g

g = $1.06 / 28.64

g = 0.0370 or

g = 3.70%

“The Growth Rate expected by the firm would be 3.70%”

Requirement (c) – Rate of Return

Sustainable Growth Rate = 5.00%

Plowback Ratio = 0.40

We know, Sustainable Growth Rate = Required Rate of Return x Plowback Ratio

5% = Required Rate of Return x 0.40

Required Rate of Return = 5.00% / 0.40

Required Rate of Return = 12.50%

“Hence, the rate of return earned by the firm on its new investments would be 12.50%”