In March 2001, Fly Paper’s stock sold for about $73. Security analysts were forecasting a long-term earnings growth rate of 8.5 percent. The company was paying dividends of $1.68 per share.

a. Assume dividends are expected to grow along with earnings at g = 8.5 percent per year in perpetuity. What rate of return r were investors expecting?

b. Fly Paper was expected to earn about 12 percent on book equity and to pay out about 50 percent of earnings as dividends. What do these forecasts imply for g? For r? Use the perpetual-growth DCF formula.