Ravi equity shares 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 expected rate of return?
2. if the investor requires a 17% return should he purchase the stock?
Answers
Answer:
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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.