A company currently pays a dividend of $2.40 per share. The current price of the stock is $18.22. It expects the growth rate of the dividend to be 2.5% (0.025) annually. What is the required return rate for this stock according to the dividend-discount model

The required rate of return is 16%

Explanation:

The constant growth model of the DDM is used whenever the dividends are expected to grow at a constant rate in the future forever. The formula for the constant growth model to calculate the price of the share today is,

P0 = D1 / r-g

Where D1 is dividend next year or D0 * (1+g)

r is the required rate of return

g is the growth rate in dividends

Plugging in the available variables, we can calculate the required rate of return (r).

18.22 = 2.4 * (1+0.025) / r - 0.025

18.22 * (r-0.025) = 2.46

18.22r - 0.4555 = 2.46

18.22r = 2.46 + 0.4555

r = 2.9155 / 18.22

r = 0.1600 or 16.00%