Eastern Electric currently pays a dividend of about $1.71 per share and sells fo

Question

Eastern Electric currently pays a dividend of about $1.71 per share and sells for $46 a share.

a. If investors believe the growth rate of dividends is 6% 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 9.94 %

b. If investors' required rate of return is 12%, 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 8 %

c. If the sustainable growth rate is 6% and the plowback ratio is .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 15 %

Explanation / Answer

price = dividend next year /(required rate of return - growth rate)

a)

46 = 1.71*(1+6%)/(r -6%)

=>

rate of return r = 9.94%

b)

46 = 1.71*(1+g)/(12%-g)

=>

5.52 -46g = 1.71 + 1.71g

growth rate g = 8%

c)

sustainable growth rate = ROE * (plowback ratio)

=>

ROE = 6%/(0.4)

= 15%

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