Tom Laboratory's common stock is currently selling at $60 per share. The next annual dividend is...

Question:

Tom Laboratory's common stock is currently selling at $60 per share. The next annual dividend is expected to be $3 per share, and the earnings, dividends, and stock prices are expected to grow at a rate, of (a) 0 percent, (b) 4 percent, and (c) 6 percent.

What is the expected total return in each case from the purchase of the common stock?

Required Rate of Return at Different Growth Rates

The required rate of return on a common stock consists of dividend yields and capital gains. The stock is expected to grow at a rate perpetually. The growth rate implies the future economics of business, market and industry growth trends, and the economy as a whole.

Answer and Explanation:

Given the following information about Tom Laboratory,

{eq}P_0 =$60 {/eq}

{eq}D_1 = $3 {/eq}

The expected return on the common stock for each of these growth rates can be calculated as follows:

{eq}R_E = D_1/P_0 + g {/eq}

Using growth rate of 0%, the return on the stock is:

{eq}R_E = $3/$60 + 0.00 {/eq}

{eq}R_E = 0.05+0.00 {/eq}

{eq}R_E = 0.05*100 = 5\% {/eq}

Therefore, the required rate of return on the stock is 5%.

The expected return on the stock using the growth rate of 4% is 9%.

{eq}R_E = $3/$60 + 0.04 {/eq}

{eq}R_E = 0.05+0.04 {/eq}

{eq}R_E = 0.09*100 = 9\% {/eq}

The expected return on the stock using the growth rate of 6% is 11%.

{eq}R_E = $3/$60 + 0.06 {/eq}

{eq}R_E = 0.05+0.06 {/eq}

{eq}R_E = 0.11*100 = 11\% {/eq}


Learn more about this topic:

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The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
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