Last year, when the stock of Waldo, Inc., was selling for $28 a share, the dividend yield was 3.5 percent. Today, the stock is selling for $35 a share. What is the required return on this stock if the company maintains a constant dividend growth rate of 5 percent?

The required rate of return on the stock is 8.087%

Explanation:

The constant growth model of DDM is used to calculate the price of a stock whose dividends are expected to grow at a constant rate forever. The DDM values a stock based on the present value of the expected future dividends from the stock. The price of the stock under this model can be calculated as,

P0 = D0 * (1+g) / (r - g)

Where,

To calculate the r or required rate of return, we first need to determine the dividend that was paid last year. Then we will apply the constant growth rate to that dividend to calculate the dividend today or D0. We will them input the value of stock price, the current dividend and the dividend growth rate in the formula above to calculate the required rate of return.

Dividend per share - Last year

Dividend yield = Dividend per share / Price per share

0.035 = Dividend per share / 28

0.035 * 28 = Dividend per share

Dividend per share = $0.98

The dividend per share today (D0) is,

D0 = 0.98 * (1+0.05)

D0 = $1.029

35 = 1.029 * (1+0.05) / (r - 0.05)

35 * (r - 0.05) = 1.08045

35r - 1.75 = 1.08045

35r = 1.08045 + 1.75

r = 2.83045 / 35

r = 0.08087 or 8.087%

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