Question

Question 1

Eastern Electric currently pays a dividend of about $1.64 per share and sells for $27 a share.

1. If investors believe the growth rate of dividends is 3% per year, what rate of return do they expect to earn on the stock?
2. If investors’ required rate of return is 10%, what must be the growth rate they expect?
3. If the sustainable growth rate is 5% and the plowback ratio is 0.4, what must the rate of return earned by the firm on its new investments?

Answer 1

Question 1 :

a. As per the Gordon Growth Model:

Po = $27

D0= $1.64

g = 3%

So, the rate of return on stock is :

Re = D1/Po + g

= $1.64*1.03/ $27 + 0.03

= 9.26% ( rounded off to two decimal places)

b. If the required return is 10%, the growth rate should be :

Re = 1.64* (1 + g) / $27 + g

10% = 1.64* (1 + g) / $27 + g

0.1/ 1.64 = [ (1 + g) + 27g ] / 27

0.1* 27 = 1.64 + 1.64g + 27g

g = 3.7%

c. The return on equity can be calculated as :

The retention ratio = 0.4

The growth rate is = 5%

So,

(0.4) * ROE = 0.05

ROE = 12.5%

So, the rate of return on new investments is 12.5%.