Assume the expected growth rate in dividends is 7%. Then the constant growth model suggests that the required return on Big Hat stock is:

Question

Quizplus · Accepted Answer

The constant growth model formula is:

P0 = D1 / (r - g)

Where:
P0 = current stock price
D1 = expected dividend next year
r = required return
g = expected growth rate in dividends

We are given that g = 7% and we want to find r. We can use the formula and solve for r:

r = D1 / P0 + g

We do not have information about the current stock price or the next year's dividend, so we cannot use this formula directly. However, we know that the answer choices are all percentages, which suggests that we can use the general rule of thumb for the required return:

r = dividend yield + expected growth rate in dividends

The dividend yield is simply the annual dividend divided by the stock price, and we are not given information about the annual dividend or stock price either. However, we can assume that the dividend yield is roughly equal to the expected long-term average yield for stocks, which is around 2% to 3%. Therefore, we can estimate the required return as follows:

r = 2% to 3% + 7% = 9% to 10%

The closest answer choice to this estimate is D, 8.4%. Therefore, the best choice is D.

Assume the Expected Growth Rate in Dividends Is 7