Walter Utilities is a dividend-paying company and is expected to pay an annual dividend of $1.25 at the end of the year. Its dividend is expected to grow at a constant rate of 6.00% per year. If Walter’s stock currently trades for $16.00 per share, what is the expected rate of return?

The expected/required rate of return is 13.8125%.

Explanation:

The stock is a constant growth stock as the dividends are expected to grow constantly forever. The constant dividend growth model of DDM is used to calculate the price of such a stock today. As we already know the price, we will use the formula of the constant growth model to determine the required rate of return. The formula for constant growth model is:

P0 or Price today = D1  /  r - g

Plugging in the available known values,

16  =  1.25  /  (r - 0.06)

16 * (r - 0.06)  =  1.25

16r  -  0.96  =  1.25

16r = 1.25 + 0.96

r = 2.21 / 16

r = 0.138125  or  13.8125%

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