Two retail corporations, both equity financed with no debt, are essentially in t

Question

Two retail corporations, both equity financed with no debt, are essentially in the same business. However, whereas one of the corporations has a stable earnings and dividend record, paying out all its earnings in dividends, the other is a growth stock increasing its earnings and dividends annually through a different management strategy. The current dividend is $5 per share for both corporations. The stable corporation’s stock trades for $40 per share, whereas the price of the growth stock is $50.

Part A: Estimate the investors’ required rate of return on these stocks

Part B: Estimate the steady future growth rate of the growing corporation as perceived by the market.

PLEASE SHOW ALL CALCULATIONS AND FORMULAS. THANK YOU

Explanation / Answer

Gordon growth model is used for determining the required return.

Price of stock= D1/Ke-g

Po=D0(1+g)/Ke-g

D0 is dividend in the current year.

D1 is dividend declared at the end of the next year

Ke is required rate of return

G is growth rate of dividend

Calculate required rate of return using stable earnings and dividend and the growth rate is zero.

Price of the stock=D0*(1+g)/Ke-g)

40=5*(1+0)/(Ke-0)

Ke=5/40=0.125 or 12.5%

Therefore required return is 12.5%

Lets calculate the growth rate of stock with growing earnings and dividends

Price of the stock=D0*(1+g)/Ke-g)

50=5*(1+g)/ (0.125-g)

050*0.125-50*g=5*(1+g)

6.25-50g=5+5g

1.25=55g

g=0.027

Therefore the growth rate of dividend is 2.7%

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