Question

The Shell Company currently has a policy of paying out 30% of its earnings in dividends. Currently the market is expecting a return on equity if 10%. The firm has just paid a dividend of $1 and the current stock price is $10. What is required rate of return on Shell stock ?

Answer 1

Payout Ratio = 0.30

Retention Ratio = 1 - Payout Ratio
Retention Ratio = 1 - 0.30
Retention Ratio = 0.70

Return on Equity = 10.00%

Growth Rate = Return on Equity * Retention Ratio
Growth Rate = 10.00% * 0.70
Growth Rate = 7.00%

Current Dividend = $1.00

Expected Dividend = Current Dividend * (1 + Growth Rate)
Expected Dividend = $1.00 * 1.07
Expected Dividend = $1.07

Required Return = Expected Dividend / Current Price + Growth Rate
Required Return = $1.07 / $10.00 + 0.07
Required Return = 0.1070 + 0.0700
Required Return = 0.1770 or 17.70%

Therefore, required rate of return on Shell stock is 17.70%