VALUATION OF A CONSTANT GROWTH STOCK Investors require a 16% rate of return on L
ID: 2617573 • Letter: V
Question
VALUATION OF A CONSTANT GROWTH STOCK
Investors require a 16% rate of return on Levine Company's stock (i.e., rs = 16%).
What is its value if the previous dividend was D0 = $3.50 and investors expect dividends to grow at a constant annual rate of (1) -2%, (2) 0%, (3) 7%, or (4) 13%? Do not round intermediate calculations. Round your answers to two decimal places.
(1) $
(2) $
(3) $
(4) $
Using data from part a, what would the Gordon (constant growth) model value be if the required rate of return was 15% and the expected growth rate was (1) 15% or (2) 20%? Are these reasonable results?
These results show that the formula makes sense if the required rate of return is equal to or less than the expected growth rate.
These results show that the formula makes sense if the required rate of return is equal to or greater than the expected growth rate.
These results show that the formula does not make sense if the expected growth rate is equal to or less than the required rate of return.
These results show that the formula does not make sense if the required rate of return is equal to or less than the expected growth rate.
These results show that the formula does not make sense if the required rate of return is equal to or greater than the expected growth rate.
-Select-IIIIIIIVVItem 5
Is it reasonable to think that a constant growth stock could have g > rs?
It is not reasonable for a firm to grow indefinitely at a rate equal to its required return.
It is not reasonable for a firm to grow indefinitely at a rate higher than its required return.
It is reasonable for a firm to grow indefinitely at a rate higher than its required return.
It is not reasonable for a firm to grow even for a short period of time at a rate higher than its required return.
It is not reasonable for a firm to grow indefinitely at a rate lower than its required return.
-Select-IIIIIIIVVItem 6
Explanation / Answer
1). here we proceed by DDM with expected return = 16% and growth is at say -2%.
D0 = 3.50. D1 = 3.50 * ( 1- 0.02) = 3.43 and terminal value for this = 3.43 / ( 0.16 - (-0.02)) = 19.056. Now we find the PV of this terminal value of constant grwoing stock = 19.056 / (1.16)^1 = 16.42.
Value of stock =16.42 + 3.50=$19.92
Simiarly for the other 3 cases we get Values as $22.36, $45.11, $135.33 respectively.
2). The condition is that " expected rate of return > expected grwoth rate". Note no equality is there. This is because this will make stock price negative which also indicated that firm cannot grow at a rate higher than required return indefinitely. So according to this options C,D,E all are correct. But the best option is D.
3). Here both options A and B are correct, but still more appropriate is option B, just in case if equality hold somewhere but growth rate can never ever be greater than required return for any case to grow indefinitely.
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