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14 October, 19:58

A firm pays a current dividend of $1 which is expected to grow at a rate of 5% indefinitely. If current value of the firm's shares is $35, what is the required return applicable to the investment based on the constant-growth dividend discount model (DDM) ?

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  1. 14 October, 20:18
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    8%

    Explanation:

    We know that

    Value of stock = Next year dividend : (Required rate of return - growth rate)

    where,

    Next year dividend would be

    = $1 + $1 * 5%

    = $1 + 0.05

    = $1.05

    The other items rate would remain same

    Now put these values to the above formula

    So, the value would equal to

    $35 = $1.05 : (Required rate of return - 5%)

    (Required rate of return - 5%) = $1.05 : $35

    (Required rate of return - 5%) = 3%

    So, the required rate of return would be

    = 3% + 5%

    = 8%
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