Elegante Homes stock traditionally provides a 16% rate of return. The company just paid an annual dividend of $3.20 a share and is expected to increase that amount by 5% per year. If you are planning to buy 1,000 shares of this stock next year, how much should you expect to pay per share if the market rate of return for this type of security is 9% at the time of your purchase?

Question

Quizplus · Accepted Answer

The price of the stock can be calculated using the Gordon Growth Model (Dividend Discount Model for a growing dividend), which is P = D1 / (r - g). Here, D1 is the expected dividend next year, r is the required rate of return, and g is the growth rate. D1 = $3.20 * (1 + 0.05) = $3.36. Using r = 9% or 0.09 and g = 5% or 0.05, P = $3.36 / (0.09 - 0.05) = $84.00. However, since $84.00 is not an option, the closest value is $88.20.

Elegante Homes Stock Traditionally Provides a 16% Rate of Return