Question

Your company had net income of $100,000 for the year just ended. Dividends of $52,750 were paid on the company's beginning equity of $1,100,000. If the company has 76,000 common shares outstanding with a current market price of $9.25 per share, what is the required rate of return on the shares assuming a constant sustainable growth rate of dividends?

	11.21%
	11.52%
	11.82%
	12.12%
	12.42%

Answer 1

Given about a company,

Net income = $100000

Dividends = $52750

Equity = $1100000

Number of shares outstanding = 76000

Current market price of share P0 = $9.25

So, dividend per share D0 = Dividend/number of shares = 52750/76000 = $0.69

Return on equity ROE = Net income/equity = 100000/110000 = 9.09%

Plowback ratio b = (Net income - Dividend)/net income = (100000 - 52750)/100000 = 47.25%

So, sustainable growth rate of the firm g = b*ROE = 0.47.25*0.0909 = 4.30%

Using constant dividend growth model, rate of return on investment Ke is

Ke = g + D0*(1+g)/P0 = 0.0430 + 0.69*(1 + 0.0430)/9.25 = 12.12%

So, required rate of return on shares = 12.12%

Option D is correct.