You purchase 100 shares of stock for $40 a share. The stock pays a $2 per share

Question

You purchase 100 shares of stock for $40 a share. The stock pays a $2 per share dividend at year-end.

a. What is the rate of return on your investment if the end-of-year stock price is (i) $38; (ii) $40; (iii) $42? (Leave no cells blank - be certain to enter "0" wherever required. Enter your answers as a whole percent.)

b. What is your real (inflation-adjusted) rate of return if the inflation rate is 4%? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places. Negative amounts should be indicated by a minus sign.)

Explanation / Answer

(a)

Using Holding Period Yield or Rate of Return on Investment

HPY = (P1 - P0 + D1)/P0

Po - Current Value of the stock

P1 - Future Value of Stock at Year 1

D1 - Dividend paid at the end year 1

(i) for end stock price is 38

HPY = (38 - 40 + 2)/40 = 0

(ii) for end stock price is 40

HPY = (40 - 40 +2)/40 = 5%

(iii)

for end stock price is 42

HPY = (42 - 40 + 2)/40 = 10%

(b)

Approximate Real Return = Nominal Return - Inflation Rate

for (i) - Real Return = 0% - 4% = 0%

for (ii) - Real Return = 5% - 4% = 1%

for (ii) - Real Return = 10% - 4% = 6%

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