The shares of ABC Ltd currently sell for $10 per share. The earnings per share is estimated at $2 for the coming year. It is said that company policy is to pay out 40% of earnings by way of dividends. The remaining earnings is then reinvested in projects that earn 20% rate of return per annum. This situation is expected to continue indefinitely.
Assuming the current market price of the stock reflects its intrinsic value as computed with the constant growth DDM, what rate of return do ABC investors require?
I understand that you have to use the DDM to calculate k. But my confusion is how do you know that the 20% rate of return is the ROE?