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Homework answers / question archive / A stock sells for $50
A stock sells for $50. The next dividend will be $4 per share. If the rate of return earned on reinvested funds is a constant 10% and the company reinvests a constant 40% of earnings in the firm, what must be the discount rate? (Do not round your intermediate calculations. Enter your answer as a whole percent.) Discount rate %
Given,
Stock price = $50
Next dividend = $4
Return on reinvested funds = 10% or 0.10
Retention rate = 40% or 0.40
Solution :-
Growth rate = Return on reinvested funds x Retention rate
= 0.10 x 0.40 = 0.04
Now,
Let discount rate be 'r'
Stock price = Next dividend/(r - growth rate)
$50 = $4/(r - 0.04)
r - 0.04 = $4/$50
r - 0.04 = 0.08
r = 0.08 + 0.04 = 0.12 or 12%
So, the discount rate must be 12%.
