Reference no: EM132938984

Question - The shares of a company currently trade at £5.20 each and a dividend of 24p has just been paid. The investor assumes that dividends will be paid annually in perpetuity and will grow in line with a constant rate of inflation. The investor estimates the assumed inflation rate from equating the price of the share with the present value of all estimated future gross dividend payments using an effective interest rate of 6%per annum.

(a) Calculate the effective annual rate of inflation based on the above assumptions.

The investor buys the shares for £5.20 each. Suppose the actual inflation rate turns out to be 3% per annum over the next 12 years, but that all the other assumptions are correct. The investor sells the shares after 12 years for £10 each, immediately after receiving the 12th dividend payment.

(b) Assuming the investor pays no tax and using trial-and-error followed by linear interpolation, calculate the investor's real rate of return from purchase to sale.

(c) Without doing any more calculations, explain how the real rate of return would change if inflation had been less than 3% per annum over the 12 years but that all the other assumptions are correct.