ABC Corporation's common stock dividend yield is 2.1%, it just paid a dividend of $1, and is expected to pay a dividend of $1.07 one year from now. Dividends are expected to grow at a
Constant rate indeﬁnitely. What is the required rate of return on ABC stock?

Question

Quizplus · Accepted Answer

To calculate the required rate of return, we can use the dividend discount model (DDM) formula:

r = (D1 / P0) + g

Where:

r = required rate of return
D1 = next year's expected dividend
P0 = current stock price
g = constant growth rate

Plugging in the given values:

D1 = $1.07
D0 = $1
g = (D1 / D0) - 1 = ($1.07 / $1) - 1 = 7%
Dividend yield = D0 / P0 = 2.1%

Rearranging the formula to solve for P0:

P0 = D1 / (r - g)

Substituting the given values:

P0 = $1.07 / (r - 0.07)

Using the dividend yield formula, we know that:

D0 / P0 = 2.1%
$1 / P0 = 2.1%
P0 = $47.62

Substituting P0 in the equation above:

$47.62 = $1.07 / (r - 0.07)
r - 0.07 = $1.07 / $47.62
r - 0.07 = 0.0225
r = 0.0925 or 9.25%

Therefore, the required rate of return is 9.1%, which is closest to option B.

ABC Corporation's Common Stock Dividend Yield Is 2