Simpson Industries Inc. pays a $1.37 dividend every quarter and will maintain this policy forever. What price should you pay for one share of common stock if you want an annual return of 12.5% on your investment?
A) $43.84
B) $43.94
C) $44.84
D) $44.94
Answer: A
Explanation: A) We use the perpetuity formula to derive the answer. When computing a perpetuity, we have to make sure that both the payment and the discount rate represent the same period. In this problem, let us use a quarter of a year (or three months) as our period. Thus, we restate the annual required rate of 12.5% as a quarterly rate of = 3.125% (or 0.03125). Applying the constant dividend model with infinite horizon and with the quarterly rate of return and a quarterly dividend of $1.37, we get: Price = = P = = $43.84. We can get the same answer using annual data. For example, the annual dividend is 4 × $1.37 = $5.48. Thus, price = = $43.84.
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