Question

10. Kangaroo Inc. stock sells for $80. The next dividend will be $4 per share. If the rate of return earned on reinvested funds is a constant 26% and the company reinvests 60% of earnings in the firm, what must be the discount rate?

Answer 1

using Gordon's model of dividend capitalisation, we have

P₀₌ E₁ (1-b)/K-br where P₀ is price of share today, E₁ is earnings per share at end of year1 b is the fraction of earnings the firm retains, k is the discount rate or rate of return required by shareholders , r is rate of return on investments made by the firm

here P₀₌ 80, b= 60% or 0.6, r = 26% or 0,26 and E₁₌$10 because company reinvests 60% and pays dividend of 40% which is $4, So earnings =10, Dividend =4 and amount retained is 6

Using the formula , we have

80= 10(1-0.6)(k-0.6*0.26)(k-0.156)

80k-12.48= 4

80k=16.48

k= 16.48/80 =0.206 or 20.6% which is the discount rate

80= 4/