Question

Norfolk Corporation earned $12.6 million for the fiscal year ending yesterday. The firm also paid out 40 percent of its earnings as dividends yesterday. The firm will continue to pay out 40 percent of its earnings as annual, end-of-year dividends. The remaining 60 percent of earnings is retained by the company for use in projects. The company has 4.2 million shares of common stock outstanding. The current stock price is $30. The historical return on equity (ROE) of 10 percent is expected to continue in the future. What is the required rate of return on the stock? (Hint: use the retention ratio and ROE to estimate the growth rate)

Answer 1

The required return is computed as shown below:

= ( D1 / P0 ) + g

g is computed as follows:

= Retention ratio x ROE

= 0.60 x 0.10

= 6% or 0.06

D1 is computed as follows:

= Current dividend x ( 1 + g )

current dividend is computed as follows:

= (Net income x 40%) / number of shares

= ($ 12.6 million x 40%) / 4.2 million shares

= $ 1.20

So, D1 will be as follows:

= $ 1.20 x 1.06

= $ 1.272

So, required rate of return will be as follows:

= ($ 1.272 / $ 30) + 0.06

= 10.24%

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