Constant-Growth Model.

Question

A stock sells for $40. The next dividend will be $4 per share. If the rate of return earned on reinvested funds is 15 percent and the company reinvests 40 percent of earnings in the firm, what must be the discount rate?

Answer 1

Using Constant-growth model, stock price P(0) = Div(1)/(r-g)

where g = rate of return on reinvested fund*retention rate = 0.15*0.40 =0.06

Hence we have, 40 = 4/(r-0.06)

==>Discount rate r = 4/40 + .06 = 0.16 = 16%