Concept explainers
To determine: The required
Introduction:
Rate of return is a loss or gain incurred on the investment made by the investors. It is expressed in terms of percentage.
Stock is a type of security in a company which denotes ownership. On issuing stocks, the company can raise capital.
Answer to Problem 35QP
The required rate of return is 12.75%.
Explanation of Solution
Given information:
SC Company has paid off dividends of $2.25 per share. The company increased dividends by 20% for the next year and the company even reduced its dividends’ growth rate by 5%. The required rate of return is 12%. The current share price of the firm is $39.52.
The formula to calculate the required rate of return using stock price formula:
Where,
Po refers to the price of the stock of the current year
Dorefers to the current year dividend paid
R refers to the required rate of return on its stock
g1refers to the expected growth
g2 refers to the constant rate of growth in second year
g3 refers to the constant rate of growthin third year
gn refers to the constant rate of growthin n number of year
Compute the required rate of return using stock price formula:
Consider the last equation above as Equation (1). This last equation can be even simplified by using trial-and-error method, so assume the required rate of return (R) as 13%. Then, substitute the value of the required rate of return in Equation (1) as shown below:
Hence, the required rate of return is not 13% since the current stock price is $39.52, and is not equal to the derived value (stock price) to the assumed required rate of return (R) as per the trial-and-error method. Next, assume the required rate of return as 12.75% to the same Equation (1 as shown below:
Hence, the required rate of return is 12.75%. It is because the current stock price is $39.52, which is equal to the derived (stock price) value to the assumed required rate of return (R) as per the trial and error method.
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Chapter 8 Solutions
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