Storico Co. just paid a dividend of $2.15 per share. The company will increase i

Question

Storico Co. just paid a dividend of $2.15 per share. The company will increase its dividend by 24 percent next year and will then reduce its dividend growth rate by 6 percentage points per year until it reaches the industry average of 6 percent dividend growth, after which the company will keep a constant growth rate forever. If the stock price is $40.71, what required return must investors be demanding on Storico stock? (Hint: Set up the valuation formula with all the relevant cash flows, and use trial and error to find the unknown rate of return.)

Explanation / Answer

D1 = 2.15*1.24 = 2.67

D2 = 2.67*1.18 = 3.15

D3 = 3.15*1.12 = 3.53

D4 = 3.53*1.06 = 3.74

Let required rate be r.

Price at year 3 = D4/(r-6%) = 3.74/(r-6%)

So current price = 2.67/(1+r) + 3.15/(1+r)^2 + 3.53/(1+r)^3 + 3.74/(r-6%)/(1+r)^3

This is equal to 40.71

So 2.67/(1+r) + 3.15/(1+r)^2 + 3.53/(1+r)^3 + 3.74/(r-6%)/(1+r)^3 = 40.71

By trial and error, we can calculate r = 13.61%

Hope this helped ! Let me know in case of any queries.

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