Finding the Required Return

Finding the Required Return – Juggernaut Satellite Corporation earned $10 million for the fiscal year ending yesterday. The firm also paid out 20% of its earnings as dividend yesterday. The firm will continue to pay out 20% of its earnings as annual, end – of – year dividends. The remaining 80% of earnings is retained by the company for use in projects. The company has 2 million shares of common stock outstanding. The current stock price is $85. The historical return on equity (ROE) of 16% is expected to continue in the future. What is the required rate of return on the stock?

The required return of a stock consist of two components, the capital gains yield and the dividend yield.

R = D₁/P₀ + g

We can find the dividend growth rate by the growth rate equation, or:

g = ROE x b

g = 0.16 x 0.80

g = 0.1280 or 12.80%

This is also the growth rate in dividends. 

Dividend per share = (net income x payout ratio) / share outstanding

Dividend per share = ($10,000,000 x 0.20) / 2,000,000

Dividend per share = $1,00

R = D₁/P₀ + g

R = $1(1 + 0.1280) / $85 + 0.1280

R = 0.1413 or 14.13%

Reference:  Chapter 9, Corporate Finance Book, Stephen A.Ross, Randolph W.Westerfield and Jeffrey Jaffe, Ninth Edition.