Answer to Question #236308 in Macroeconomics for Comfort

Question

Baskets (an all form) is reinvesting 65% of it's earnings in projects that provide a ROE of 9%. The expected return on similar risky projects is 14% on the stock market. Given the present policy on the firm it's year-end dividend is now $3 per share. At what price will the stock sell?

Answer 1

We need to use constant growth model to calculate stock price.

Stock price $(P0)=\frac{D1}{(rs-g)}$

Where

D1 =dividend for next years

rs =expected return 

g=Growth rate 

Growth rate (g) =ROE$\times$ Retention ratio

              $=9\%×0.65\\ =5.85\%$

Dividend for next year$(D1) =\$3(1+0.0585)$

           $=\$3.1755$

Expected return(rs) =14%

  Stock price $(P0) =\frac{3.1755}{(0.14-0.0585)}$

               $=\frac{3.1755}{0.0815}\\ =38.96$

hence stock price is $38.96