King Waterbeds has an annual cash dividend policy that raises the dividend each year by 4 %. The most recent dividend, Div 0 , was $ 0.40 per share. What is the stock's price if a. an investor wants a return of 5 %? b. an investor wants a return of 8 %? c. an investor wants a return of 10 %? d. an investor wants a return of 13 %? e. an investor wants a return of 20 %?

Answer: a) $42

b) $10.5

c) $7

d) $4.67

e) $2.63

Explanation:

We can use the Gordon Growth Model of Stock Valuation to find out these answers.

The formula is,

P = D1 / r - g.

D1 = the annual expected dividend of the next year.

r = rate of return.

g = the expected dividend growth rate (assumed to be constant)

To calculate Next year's dividend (D1) we can use the growth rate as follows,

D1 = D0 (1+g)

D1 = 0.4 (1+0.04)

D1 = $0.416

D1 = $0.42

Now that we have D1 we can use it for all the questions.

a) an investor wants a return of 5 %

= D1 / r - g.

= 0.42 / 0.05 - 0.04

= $42

b) investor wants a return of 8 %

= D1 / r - g

= 0.42 / 0.08 - 0.04

= $10.5

c) investor wants a return of 10 %

= D1 / r - g

= 0.42 / 0.1 - 0.04

= $7

d) investor wants a return of 13 %

= D1 / r - g

= 0.42 / 0.13 - 0.04

= $4.67

e) investor wants a return of 20 %

= D1 / r - g

= 0.42 / 0.2 - 0.04

= $2.63

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