Question

Your company had net income of $120,000 for the year just ended. Dividends of $72,750 were...

Your company had net income of $120,000 for the year just ended. Dividends of $72,750 were paid on the company's beginning equity of $1,320,000. If the company has 92,000 common shares outstanding with a current market price of $11.25 per share, what is the required rate of return on the shares assuming a constant sustainable growth rate of dividends?

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Answer #1

Given about a company,

Net income = $120000

Dividends = $72750

Equity = $1320000

Number of shares outstanding = 92000

Current market price of share P0 = $11.25

So, dividend per share D0 = Dividend/number of shares = 72750/92000 = $0.79

Return on equity ROE = Net income/equity = 120000/1320000 = 9.09%

Plowback ratio b = (Net income - Dividend)/net income = (120000 - 72750)/120000 = 39.38%

So, sustainable growth rate of the firm g = b*ROE = 0.3938*0.0909 = 3.58%

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

Ke = g + D0*(1+g)/P0 = 0.0358 + 0.79*(1 + 0.0358)/11.25 = 10.86%

So, required rate of return on shares = 10.86%

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