Common stock valuation Dalton Inc has a return on equity of

(Common stock valuation) Dalton Inc. has a return on equity of 12.5 percent and retains 54 percent of its earnings for reinvestment purposes. It recently paid a dividend of $3.50 and the stock is currently selling for $38 a. What is the growth rate for Dalton Inc.? b. What is the expected return for Dalton\'s stock? c. If you require a 13 percent return, should you invest in the firm? a. What is the growth rate for Dalton Inc.? % (Round to two decimal places.) b. What is the expected return for Dalton\'s stock? % (Round to two decimal places.) c. If you require a 13 percent return, should you invest in the firm? ?- (Select from the drop-down menu.)

Solution

Answer a.

Return on Equity, ROE = 12.5%
Retention Ratio, b = 0.54

Growth Rate = [ROE * b] / [1 - ROE * b]
Growth Rate = [12.5% * 0.54] / [1 - 12.5% * 0.54]
Growth Rate = 0.0675 / 0.9325
Growth Rate = 0.0724
Growth Rate = 7.24%

Answer b.

Recent Dividend, D0 = $3.50
Growth Rate, g = 7.24%
Current Price, P0 = $38.00

D1 = D0 * (1 + g)
D1 = $3.50 * 1.0724
D1 = $3.7534

Expected Return = D1 / P0 + g
Expected Return = $3.7534 / $38.00 + 0.074
Expected Return = 0.1728
Expected Return = 17.28%

Answer c.

If required return is 13%, then you should invest in this firm.