The common stock of Average Corporation is selling for $10 a share and is expected to pay a dividend of $0.50 a share next year. If dividends are expected to grow at a constant rate of 4%
Indefinitely, what is the market requiring as a return on this company's stock?

Question

Quizplus · Accepted Answer

We can use the constant growth formula to calculate the required return on the stock:
Required Return = (Dividend Yield + Expected Growth Rate)
Dividend Yield = Dividend/Stock Price = 0.50/10 = 5%
Expected Growth Rate = 4%
Required Return = 5% + 4% = 9% The dividend growth rate of 4% and the expected dividend of $0.50 can be used to calculate the expected dividend for the next period:
Expected Dividend = $0.50 x (1 + 4%) = $0.52
The market required rate of return can then be determined using the constant growth dividend discount model:
$10 = $0.52 / (r - 4%)
r = 8% + 4% = 12%
Therefore, the market is requiring a return of 12% on Average Corporation's stock.

The Common Stock of Average Corporation Is Selling for $10