Question

At the beginning of the year, GDL was considered a mature company and everyone expected its dividend to grow at a constant rate of 2.8% per year, and everyone also expected the company would pay a dividend of $4.9 exactly one year from now. The required return for the company is 11%.

Suppose that at the end of the year, the company pays the expected dividend amount, but some unexpected good news about the company is revealed, and everyone now expects the company to grow at a constant rate of 7% per year forever.

If you bought the company at the beginning of the year and then sold it at the end of the year (after collecting the dividend and after the good news was revealed), what was your 1-year return on your investment in GDL stock?

Answer 1

Beginning of the year:

Expected dividend, D1 = $4.90
Growth rate, g = 2.80%
Required return, r = 11.00%

Purchase Price = D1 / (r - g)
Purchase Price = $4.90 / (0.11 - 0.028)
Purchase Price = $59.76

End of the year:

Growth rate, g = 7.00%

D2 = $4.90 * 1.07
D2 = $5.243

Selling Price = D2 / (r - g)
Selling Price = $5.243 / (0.11 - 0.07)
Selling Price = $131.08

Holding Period Return = (Selling Price + Dividend Received - Purchase Price) / Purchase Price
Holding Period Return = ($131.08 + $4.90 - $59.76) / $59.76
Holding Period Return = 1.2754 or 127.54%