Storico Co. just paid a dividend of $1.90 per share. The company will increase i

Question

Storico Co. just paid a dividend of $1.90 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 $31.32, 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.) (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Explanation / Answer

Answer: Here we want to find the required return that makes the PV of the dividends equal to the current stock price. The equation for the stock price is:

P = $1.90(1.20) / (1 + R ) + $1.90(1.20)(1.15) / (1 + R ) 2 + $1.90(1.20)(1.15)(1.10) / (1 + R ) 3 + [$1.90(1.20)(1.15)(1.10)(1.05) / ( R - 0.05)] / (1 + R ) 3 = $31.32

We need to find the roots of this equation. Using a spreadsheet, trial and error, or a calculator with a root solving function, we find that:

R = 13.25%

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