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CFA Level I · CFA Level I Exam · Discounted Cash Flow (DCF) and Growth Models

A stock just paid a dividend of $3.00 per share. Dividends are expected to grow at 5% indefinitely. The stock trades at $63.00, and the Gordon growth model is assumed to hold. The market-implied required rate of return is closest to:

The implied required return is about 10.0%. The next dividend is $3.00 times 1.05, or $3.15; dividing by the $63.00 price gives a 5% dividend yield, and adding 5% growth gives 10.0%. Using the current dividend instead would understate the return at 9.8%.

  1. A9.8%
  2. B10.0%Correct
  3. C10.2%

Explanation

D1 = 3.00 x 1.05 = 3.15. Rearranging V0 = D1/(r - g) gives r = D1/V0 + g = 3.15/63 + 0.05 = 0.05 + 0.05 = 10.0%. Using D0 instead of D1 gives 3/63 + 5% = 9.76%, about 9.8%.

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