Question

Laurel Enterprises had earnings last year $4 per share and has a constant 40% retention rate. Its equity cost of capital is 10%. The expected return on new investment is 10%. If next dividend due in one year (i.e., one year from today), what is current stock price?

Group of answer choices

$66.67

$16.00

$40.00

$41.60

Answer 1

The current stock price is computed as shown below:

= Next year dividend ( cost of capital - growth rate)

growth rate is computed as follows:

= retention rate x return on investment

= 0.40 x 0.10

= 4% or 0.04

Next year dividend is computed as follows:

= Last year EPS x (1 - retention ratio) x (1 + growth rate)

= $ 4 x (1 - 0.40) x (1 + 0.04)

= $ 2.496

So, the price will be computed as follows:

= $ 2.496 / (0.10 - 0.04)

= $ 41.60

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