Storico Co. just paid a dividend of $1.60 per share. The company will increase i

Question

Storico Co. just paid a dividend of $1.60 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 34.08, 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) = 1.60 * 1.20 = 1.92

Dividend in year 2 (D2) = 1.92 * 1.15 = 2.208

Dividend in year 3 (D3) = 2.208 * 1.1 = 2.4288

Dividend in year 4 (D4) = 2.4288 * 1.05 = 2.55024

Let required return be r.

Price in year 3 (P3) = D4 / (r-growth rate) = 2.55024 / (r-5%)

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

34.08 = 1.92 / (1+r) + 2.208 / (1+r)^2 + 2.4288 / (1+r)^3 + 2.55024 / (r-5%) / (1+r)^3

Using trial and error for r, we find r = required return = 11.40%

Answer: Required return = 11.40%

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

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.