Steady As She Goes Inc. will pay a year-end dividend of $3.40 per share. Investors expect the dividend to grow at a rate of 5% indefinitely.

a. If the stock currently sells for $34.00 per share, what is the expected rate of return on the stock?

b. If the expected rate of return on the stock is 16.5%, what is the stock price?

a.

15%

b.

29.57

Explanation:

The price of a stock whose dividends are expected to grow at a constant rate forever can be calculated using the constant growth model of the dividend discount model approach. The DDM values the stock based on the preset value of the expected future dividends from the stock. The price of the stock today under this model is,

P0 = D1 / r - g

Where

P0 = Price of stock

D1 = Future Dividend

r = Expected rate of return

g = Growth rate

a.

As we have the price of the price of the stock, we need to calculate the expected rate of return by extracting the formula.

r = (D1 / P0) + g

As per given data

P0 = Price of stock = $34

D1 = Future Dividend = $3.40

g = Growth rate = 5% = 0.05

Placing Values in the formula

r = ($3.4 / 34) + 0.05

r = 0.15 = 15%

b.

As per given data

D1 = Future Dividend = $3.40

g = Growth rate = 5% = 0.05

r = Expected rate of return = 16.5%

Placing Values in the formula

P0 = D1 / r - g

P0 = $3.40 / (16.5% - 5%)

P0 = $29.57