The stock of Nogro Corporation is currently selling for $10 per share. Earnings

Question

The stock of Nogro Corporation is currently selling for $10 per share. Earnings per share in the coming year are expected to be $2. The company has a policy of paying out 50% of its earnings each year in dividends. The rest is retained and invested in projects that earn a 20% rate of return per year. This situation is expected to continue indefinitely.

Assuming the current market price of the stock reflects its intrinsic value as computed using the constant-growth DDM, what rate of return do Nogro’s investors require? (Do not round intermediate calculations.)

The stock of Nogro Corporation is currently selling for $10 per share. Earnings per share in the coming year are expected to be $2. The company has a policy of paying out 50% of its earnings each year in dividends. The rest is retained and invested in projects that earn a 20% rate of return per year. This situation is expected to continue indefinitely.

Explanation / Answer

D1( Dividentd) =E× (1–b)

b=divdidend payout ratio

                        = $2 × (1-0.50)= $1

growth=b× ROE = 0.5 × 0.20

= 0.10 or 10%

Therefore:

r=D1/P0 + g

   =$1/$10 + 0.10

   =0.20

    =20%

Rate of return=20%

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