McIntyre's Moats, Inc. currently pays no dividends, but the firm will begin paying dividends in three years. The first dividend will be $2.50 and dividends are expected to grow at 2% thereafter. Given a current market price of $55.62, what is the required return on the stock?

Question

Quizplus · Accepted Answer

The required return on the stock can be calculated using the Gordon Growth Model (Dividend Discount Model for a perpetually growing dividend), which is P = D / (r - g), where P is the price, D is the dividend, r is the required return, and g is the growth rate. Here, the dividend in three years (D1) is $2.50, and it grows at 2% thereafter. Since the dividend starts in three years, we need to discount it back to present value, which means we are actually looking for the price today of a dividend that starts being paid in year 4. The formula modifies to P0 = D1 / ((r - g) * (1 + r)^3), where D1 is the dividend in year 4, which is $2.50 * (1 + 0.02) = $2.55. Plugging the values into the formula and solving for r gives us the required return. By trial and error or using a financial calculator, we find that the required return that fits this equation is approximately 6.6%.