Ravi equity share currently sells for 23 per share. The company's finance manager anticipates a constant growth rate of 10.5% and an end of year dividend of 2.50
1. what is the expected rate of return?
2. if the investor requires a 17% return, should he purchase the stock?
Answers
The expected rate of return is 21.37% and if the investor requires a 17% return, he should purchase the stock.
Explanation:
Case 1: Finding the expected rate of return
The current market price for Ravi = Rs. 23 per share
The constant growth rate = 10.5%
The dividend at the end of the year = Rs. 2.50
Thus,
The expected rate of return is,
= [{(Dividend in 1 year)/(Market Price)}*100] + Growth Rate
= [{(2.50)/(23)}*100] + 10.5
= 10.869 + 10.5
= 21.37%
Case 2: Finding the value of the share if the rate of return required by the investor is 17%
Here the required rate of return is given as 17% by the investor
Therefore,
The market value of the share will be,
= [Dividend in 1 year] / [{(Required rate) – (Growth rate)}*100]
= [2.50] / [{(17) – (10.5)}*100]
= [2.50] / [{(17) – (10.5)}*100]
= 2.50 / 0.065
= Rs. 38.46
Thus, the market value of the share (Rs. 38.46) is greater than the current market price (Rs. 23) for Ravi as the expected rate of return calculated in the case (1) is greater than the required rate of return of 17%.
Hence, the investor should buy the stock from Ravi.
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1. The expected rate of return is
2. If the investor requires a 17% return, so he should purchase the stock
Explanation:
We use the Gordon model in this question
1. Below is the measurement of the expected rate of return:
Expected rate of return = (Year end dividend) ÷ (Selling price per share) + Constant growth rate
= ($2.50) ÷ ($23) + 10.5%
= 10.86% + 10.5%
= 21.37%
2. And, to determine whether the stock is purchase or not, we have to determine the value of the stock which is calculated below
= (Year end dividend) ÷ (Required return rate - constant growth rate)
= ($2.50) ÷ (17% - 10.5%)
= ($2.50) ÷ (6.5%)
= $38.46
Since in the question, the selling per share is $23 per share and the value of the stock which is calculated above is $38.46 which shows that this value per share is more than the selling price per share.
Hence, the stock should be purchased
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C. cannot be used to value constant dividend-paying stocks.
D. requires that the dividend growth rate be less that the required rate of return.
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