Question

(Common stock valuation) Dalton Inc. has a return on equity of 12.1 percent and retains 56 percent of its earnings for reinvestment purposes. It recently paid a dividend of $3.25 and the stock is currently selling for $38.

a. What is the growth rate for Dalton Inc.?

b. What is the expected return for Dalton's stock?

c. If you require a 12 percent return, should you invest in the firm?

Answer #1

As we know, Return on equity (Ke) = 12.1% or 0.121

Retention ratio = 56%

Recent Dividend (D0) = $3.25

Current selling Price (P0) = $38

a) We know that, Ke = D1/P0 + g, where g is growth rate

D1 is expected dividend

Since we know current dividend = $3.25

Current earnings will be = $3.25/44% = $7.39

Therefore, D1 will be = (7.39+g)*0.44

Therefore, 0.121=((7.39+g)*0.44/38) + g

0.121-g = (3.25+0.44g)/38

4.60 - 38g = 3.25 + 0.44g

4.60-3.25 = 38g + 0.44g

growth rate or g = 0.0351 or 3.51%

b) Since we know growth rate (g) = 3.51%

and D1 = (7.39+g)*0.44

therefore, D1 = (7.39+0.0351)*0.44 = 3.27

Expected return = D1/P0 = 3.27/38 = 0.0861 or 8.61%

c) Since the expected return is 8.61% and required return is 12.1% therefore, you should not invest in this firm.

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