Question

Pagemaster just reported earnings of $2 million. They are retaining 40% of those earnings ($800,000), and paying out 60% as a dividend. The historical ROE for the firm is 16% per year and the company has 1,000,000 shares outstanding selling at $10 per share. What is the required return ("r") for Pagemaster?

Answer 1

Step-1, Calculation of the Dividend Growth rate

Growth Rate (g) = ROE x Retention Ratio

= 16% x 0.40

= 6.40%

Step-2, Calculation of Dividend per share (D0)

Dividend per share (D0) = Dividend Paid / Number of Common Shares

= [$20,00,000 x 60%] / 10,00,000 Shares

= $12,00,000 / 10,00,000 Shares

= $1.20 per share

Step-3, Calculation of the Required Rate of Return

As per Dividend Discount Model, The Required Rate of Return = [D1 / P0] + g

= [($1.20 x 1.0640) / $10] + 0.0640

= [$1.28 / $10] + 0.0640

= 0.1277 + 0.0640

= 0.1917

= 19.17%

“Therefore, the Required Rate of Return for Pagemaster would be 19.17%”