Question

Eastern Electric currently pays a dividend of about $1.67 per share and sells for $40 a share.

a.	If investors believe the growth rate of dividends is 5% per year, what rate of return do they expect to earn on the stock? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Rate of return

%

b.	If investors' required rate of return is 10%, what must be the growth rate they expect of the firm? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Growth rate

%

c.	If the sustainable growth rate is 2% and the plowback ratio is .2, what must be the rate of return earned by the firm on its new investments? (Enter your answer as a percent rounded to 2 decimal places.)

Rate of return

%

Answer 1

a) g = 5%

D1 = $1.67 * (1 + 5%) = $1.7535

r - 0.05 = 1.7535/40 = 0.0438

r = 0.0938 = 9.38%

b) r = 10%

D1 = $1.67 * (1 + g)

4 - 40g = 1.67 + 1.67g

2.33 = 41.67g

g = 5.59%

c) Sustainable growth rate = ROE * Plowback ratio

ROE = 2%/0.2 = 10.0%