Question

​(Common stock valuation​) Dalton Inc. has a return on equity of 11.1 percent and retains 55 percent of its earnings for reinvestment purposes. It recently paid a dividend of ​$3.50 and the stock is currently selling for ​$44.

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?

a. What is the growth rate for Dalton​ Inc.? (Round to two decimal​ places.)

Answer 1

Answer a.

Retention Ratio = 0.55
Return on Equity = 11.10%

Growth Rate = Retention Ratio * Return on Equity
Growth Rate = 0.55 * 11.10%
Growth Rate = 6.11%

Answer b.

Last Dividend = $3.50
Current Price = $44.00

Expected Dividend = Last Dividend * (1 + Growth Rate)
Expected Dividend = $3.50 * 1.0611
Expected Dividend = $3.71385

Expected Return = Expected Dividend / Current Price + Growth Rate
Expected Return = $3.71385 / $44.00 + 0.0611
Expected Return = 0.0844 + 0.0611
Expected Return = 0.1455 or 14.55%

Answer c.

If required return is 12.00% which is lower than the expected return of 14.55%, then the firm should invest in this stock.