Question

4. A broker offers to sell you shares of Bay Area Healthcare, which just paid a dividend of $2 per share. The dividend is expected to grow at a constant rate of 5% per year. The stock's price is $30 a share. The stock's required rate of return is 12%. What is the expected capital gains yield at the end of the third year? Choice: 2.5% (ADM) con lo mostogo sobom Choice: 5.0% Choice: 7.5% wool blog o barobivib M a in Choice: $30 at end of year wi g store

Answer 1

Given for Bay Area Healthcare,

D0 = $2

g = 5%

Ke = 12%

P0 = $30

Using Gordon Growth model

Price at the start of third years = D3/(Ke-g)

P2 = D0*((1+g)^3)/(Ke -g) = 2*1.05^3/(0.12-0.05) = $33.075

Similarly Price at end of year 3 = D4/(Ke-g)

P3 = D0*(1+g)^4)/(Ke-g) = 2*1.05^4/(0.12-0.05) = $34.73

So capital gain in 3rd year = (P3-P2)/P2 = (34.73 - 33.075)/33.075 = 5%