Storico Co. just paid a dividend of $1.50 per share. The company will increase i
ID: 2759213 • Letter: S
Question
Storico Co. just paid a dividend of $1.50 per share. The company will increase its dividend by 20 percent next year and will then reduce its dividend growth rate by 5 percentage points per year until it reaches the industry average of 5 percent dividend growth, after which the company will keep a constant growth rate forever. If the stock price is $24.94, 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
Here we have a stock with supernormal growth, but the dividend growth changes every year for the first four years.We can find the price of the stock in Year 3 since the dividend growth rate is constant after the third dividend. Theprice of the stock in Year 3 will be the dividend in Year 4, divided by the required return minus the constant growth rate
cost of equity = dividend /market price+growth rate
cost of equity = 1.50(1.20)(1.15)(1.10)(1.05)/24.94+0.05
= 0.0959+0.05
=0.1459
= 14.59%