Sparrow Products Industries stock is currently selling for $80. It just paid its annual dividend of $2 after reporting an ROE of 15%. The firm pays out 50% of its earnings as dividends. What is the expected return of this stock? Group of answer choices 10.71% 9.30% 10.19% 9.60% 9.52% PreviousNext

The expected return on this stock is 10.19%

Explanation:

We first need to determine the sustainable growth rate in dividends. The sustainable growth rate is,

Sustainable growth rate (g) = ROE * RR

Where,

RR is the retention ratio or (1 - Dividend Payout Ratio)

Sustainable growth rate (g) = 0.15 * (1-0.5) = 0.075 or 7.5%

To calculate the required/expected return on this stock, we will use the constant growth model of DDM as the dividends are expected to grow at a constant rate because of the sustainable growth rate. The formula for price under Constant growth model is,

P0 = D0 * (1+g) / (r - g)

Plugging in the values for Price today, growth rate and D0, we can calculate the required rate of return,

80 = 2 * (1+0.075) / (r - 0.075)

80 * (r - 0.075) = 2.15

80r - 6 = 2.15

80r = 2.15 + 6

r = 8.15 / 80

r = 0.101875 or 10.1875% rounded off to 10.19%