Baker Foods made two announcements concerning its common stock today. First, the company announced that the next annual dividend has been set at $3.20 a share. Secondly, the company announced that all future dividends after that will increase by 2% annually. What is the maximum amount you should pay today to purchase one share of Baker's stock if your goal is to earn a 9% rate of return?

Question

Quizplus · Accepted Answer

The maximum amount you should pay today to purchase one share of Baker's stock, given the conditions, can be calculated using the Gordon Growth Model (also known as the Dividend Discount Model for a constantly growing dividend). The formula is P = D1 / (r - g), where P is the price of the stock today, D1 is the dividend next year, r is the required rate of return, and g is the growth rate of the dividend. Here, D1 = $3.20, r = 9% or 0.09, and g = 2% or 0.02. Plugging these values into the formula gives P = $3.20 / (0.09 - 0.02) = $3.20 / 0.07 = $45.71.

Baker Foods Made Two Announcements Concerning Its Common Stock Today