Question

Eastern Electric currently pays a dividend of $1.91 per share and sells for $30 a share. a. If investors believe the growth rate of dividends is 2% per year, what rate of return do they expect to earn on the stock? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) Rate of return % b. If investors' required rate of return is 15%, what must be the growth rate they expect of the firm? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) Growth rate c. If the sustainable growth rate is 4% and the plowback ratio is 0.4, what must be the rate of return earned by the firm on its new investments? (Enter your answer as a percent rounded to 2 decimal places.) Rate of return 1

Answer 1

a.

As per Dividend Growth Model,

P₀ = D₁ / (k - g)

D₁ = D₀ (1 + g)

= $1.91 (1 + 0.02)

D₁ = $ 1.9482

P₀ = D₁ / (k - g)

30 = 1.9482 / (k - 0.02)

k = (1.9482 / 30) + 0.02

k = 0.0849 or 8.49%

Rate of Return = 8.49%

b.

P₀ = D₁ / (k - g)

30 = 1.9482 / (0.15 - g)

0.15 = (1.9482 / 30) + g

g = 0.0851 or 8.51%

Growth Rate = 8.51%

c.

Growth Rate = Plowback Ratio * Return on Equity

0.04 = 0.4 * Return on Equity

Return on Equity = 0.1 or 10%

Rate of Return earned on Investment = 10%