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Example 7
Example 7.1 Stock Prices and Returns (1 of 4) why we are using equity cost of capital instead of rik free interest rate BECAUSE STOCKS ARE RISKY INVESTMENTS AND WE CANNOT USE RISK FREE Problem INTEREST RATE TO VALUE THEM equity cost of captal: the expected return of omer investment valable in the market with equivalent risk to Suppose you expect Longs Drug Stores to pay an the firms shares annual dividend of $0.56 per share in the coming year and to trade for $45.50 per share at the end of the year. If investments with equivalent risk to Longs' stock have an expected return of 6.80%, what is the most you would pay today for Longs' stock? What dividend yield and capital gain rate would you expect at this price? (
Expert Solution
The price is computed as shown below:
= (Dividend at end of year + Price at end of year) / (1 + return)
= ($ 0.56 + $ 45.50) / 1.068
= $ 46.06 / 1.068
= $ 43.12734082 or $ 43.13 Approximately
Dividend yield is computed as follows:
= Dividend / Price
= $ 0.56 / $ 43.12734082
= 1.30% Approximately
Capital gain rate is computed as follows:
= (Price at end - Current price) / Current price
= ($ 45.50 - $ 43.12734082 ) / $ 43.12734082
= $ 2.37265918 / $ 43.12734082
= 5.50% Approximately
Feel free to ask in case of any query relating to this question
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