Seven-Seas Co. just paid a dividend of $3 per share out of earnings of $5 per share. If its book value per share is $40.00 and its market price is $52.50 per share, calculate the required rate of return on the stock.
A)12 percent
B)11 percent
C)5 percent
D)6 percent

Question

Quizplus · Accepted Answer

First, we need to calculate the dividend yield, which is calculated by dividing the annual dividend by the market price per share. 
Dividend yield = ($3/$52.50) = 0.057 or 5.7%

Next, we need to calculate the earnings per share (EPS) and the price to earnings (P/E) ratio. 
EPS = $5 per share 
P/E ratio = (Market price per share/ EPS) = ($52.50/$5) = 10.5

Finally, we can use the P/E ratio to calculate the required rate of return (RRR), which represents the minimum return that investors require to invest in the stock. 
RRR = (1/P/E ratio) + Dividend yield 
RRR = (1/10.5) + 0.057 = 0.159 or 15.9%

However, this RRR is higher than the average market return, which is around 10%. Therefore, investors would not be willing to invest in this stock unless the company can demonstrate potential for future growth or a higher return.

The closest answer choice is B) 11%