Question

Lisa Simpson is an security analyst at Left-handed Brothers Securities and has developed the following estimates for Doh! Doughnuts common stock which is currently selling for $40 per share. The risk-free rate is 2%, the market risk premium is 8%, and Doh!'s stock has a beta of 1.2 with a current dividend of $1.80 that has an expected constant growth rate of 7.5%. What is Lisa's estimate of the expected return for Doh! Doughnut's stock?

A. 9.2%

B. 12.3%

C. 10%

D. 11.2%

E.7.5%

(answer is B, I just don't know how to ge the expected return)

Answer 1

Answer

• Whenever you see a "Constant Growth Rate" in Question of Finding Cost of Equity or Finding Stock Price, ALWAYS use "Constant Growth Formula (known as GORDON'S Formula)".
• So According to this Formula,

?Cost of Equity = { Expected Dividend (D₁) / Current Stock Price (P₀) } + Growth Rate (g)

Cost of Equity = { D₀ (1+g) / P₀ } ₊ g

Cost of Equity = { $ 1.8(1+0.075) / $40 } + 0.075

Cost of Equity = (1.935 / 40) + 0.075

Cost of Equity = 0.048 + 0.075

Cost of Equity = 0.123 ie. 12.3%

NOTE : We Calculated Expected Dividend (ie. D₁) by adding growth to it Current Year Dividend (ie. D₀?)

HOPE YOU ARE CLEAR NOW. STILL IF ANY DOUBT YOU CAN ASK IN COMMENT :)