Question

Corporations often distribute profits to their shareholders in the form of dividends, which are quarterly payments sent to shareholders. Suppose that you have the chance to buy a share in a fashion company called Rogue Designs for \(35 and that the company will pay dividends of \)2 per year on that share. What is the annual percentage rate of return? Next, suppose that you and other investors could get a 12 percent per year rate of return on the stocks of other very similar fashion companies. If investors care only about rates of return, what should happen to the share price of Rogue Designs? (Hint: This is an arbitrage situation.)

Short answer

The annual percentage rate of return is 12%.

If the investors care only about rates of return, the share price of Rogue Designs and the other very similar fashion companies will be the same.

Step-by-step solution

Step 1. Annual percentage rate of return

The annual percentage rate of return is the percentage gain or loss (relative to the buying price) over a given period of time, typically a year. The dividends of $2 per year are divided by the price of share $35 and multiplied by 100 to get the annual percentage return of 12%.

Step 2. Arbitrage

The other investor could also get a 12% per year rate of return on the stocks of other very similar fashion companies. The share price of Rogue Designs and the other fashion company will become equal. According to the concept of arbitrage, if the rate of returns on the shares of products simultaneously differs, the share price will change to equate the rate of returns.