Question

The Florida Diving Company had a return on equity (ROE) of 5% this past year. Dividends were paid of $10,000, and the company’s net income was $50,000. If the company has 100,000 shares outstanding with a current market price of $20 per share, what is the required rate of return?

Answer 1

Dividends = $10,000
Net Income = $50,000

Payout Ratio = Dividends / Net Income
Payout Ratio = $10,000 / $50,000
Payout Ratio = 20%

Retention Ratio, b = 1 - Payout Ratio
Retention Ratio, b = 1 - 0.20
Retention Ratio, b = 0.80

Growth Rate, g = ROE * b
Growth Rate, g = 5% * 0.80
Growth Rate, g = 4%

Dividend per share, D0 = Dividends / Shares outstanding
Dividend per share, D0 = $10,000 / 100,000
Dividend per share, D0 = $0.10

Current Price, P0 = $20.00

Expected Dividend, D1 = D0 * (1 + g)
Expected Dividend, D1 = $0.10 * 1.04
Expected Dividend, D1 = $0.104

Required Return, rs = D1 / P0 + g
Required Return, rs = $0.104 / $20.00 + 0.04
Required Return, rs = 0.0052 + 0.04
Required Return, rs = 0.0452 or 4.52%

So, required rate of return is 4.52%