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22 March, 23:48

King Waterbeds has an annual cash dividend policy that raises the dividend each year by 4 %. The most recent dividend, Div 0 , was $ 0.40 per share. What is the stock's price if a. an investor wants a return of 5 %? b. an investor wants a return of 8 %? c. an investor wants a return of 10 %? d. an investor wants a return of 13 %? e. an investor wants a return of 20 %?

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  1. 23 March, 00:04
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    Answer: a) $42

    b) $10.5

    c) $7

    d) $4.67

    e) $2.63

    Explanation:

    We can use the Gordon Growth Model of Stock Valuation to find out these answers.

    The formula is,

    P = D1 / r - g.

    D1 = the annual expected dividend of the next year.

    r = rate of return.

    g = the expected dividend growth rate (assumed to be constant)

    To calculate Next year's dividend (D1) we can use the growth rate as follows,

    D1 = D0 (1+g)

    D1 = 0.4 (1+0.04)

    D1 = $0.416

    D1 = $0.42

    Now that we have D1 we can use it for all the questions.

    a) an investor wants a return of 5 %

    = D1 / r - g.

    = 0.42 / 0.05 - 0.04

    = $42

    b) investor wants a return of 8 %

    = D1 / r - g

    = 0.42 / 0.08 - 0.04

    = $10.5

    c) investor wants a return of 10 %

    = D1 / r - g

    = 0.42 / 0.1 - 0.04

    = $7

    d) investor wants a return of 13 %

    = D1 / r - g

    = 0.42 / 0.13 - 0.04

    = $4.67

    e) investor wants a return of 20 %

    = D1 / r - g

    = 0.42 / 0.2 - 0.04

    = $2.63

    If you need any clarification do react or comment.
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