Question

You are interested in buying common stock in John Wagner and Associates, a company that has announced it will pay a $2 dividend next year. The company has promised that it will honor their historical practice of increasing dividends by 5% per year. The required rate of return is currently 8%. What is a fair price for a common stock share? And if you consider purchasing more stock for the John Wagner Associates; however, you discover the required rate of return has increased to 10%. Will you pay more for the stock because of the higher required rate of return?

Answer 1

Expected dividend, D1 = $2

growth rate of dividends , g = 5% = 0.05

required return, r = 8% = 0.08

fair price = D1/(r-g) = 2/(0.08-0.05) = 2/0.03 = $66.6667 or $66.67 ( rounding off to 2 decimal places)

if the required return has increased to 10% , you will not pay more for the stock, because , keeping all else constant, the price of the stock is inversely related to the required return, which means if the required return increases , the stock price decreases, which means you will pay less if required return increases.