Storico Co. just paid a dividend of $2.80 per share. The company will increase i

Question

Storico Co. just paid a dividend of $2.80 per share. The company will increase its dividend by 20 percent next year and will then reduce its dividend growth rate by 5 percentage points per year until it reaches the industry average of 5 percent dividend growth, after which the company will keep a constant growth rate forever. If the stock price is $52.96, what required return must investors be demanding on Storico stock? (Hint: Set up the valuation formula with all the relevant cash flows, and use trial and error to find the unknown rate of return.)

Explanation / Answer

Dividend in year 1 (D1) = 2.80 * 1.20 = 3.36

Dividend in year 2 (D2) = 3.36 * 1.15 = 3.864

Dividend in year 3 (D3) = 3.864 * 1.1 = 4.2504

Dividend in year 4 (D4) = 4.2504 * 1.05 = 4.46292

Let required return be r.

Price in year 3 (P3) = D4 / (r-growth rate) = 4.46292 / (r-5%)

Current stock price = D1 / (1+r) + D2 / (1+r)^2 + D3 / (1+r)^3 + P3 / (1+r)^3

52.96 = 3.36 / (1+r) + 3.864 / (1+r)^2 + 4.2504 / (1+r)^3 + 4.46292 / (r-5%) / (1+r)^3

Using trial and error for r, we find r = required return = 12.20%

Answer: Required return = 12.20%

Hope this helped ! Let me know in case of any queries.

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