Investors require a 15% rate of return on Levine Company\'s stock (that is , r s

Question

Investors require a 15% rate of return on Levine Company's stock (that is , rs=15%)

a) What is its value if the previous dividend was D0=$2 and investors expect dividends to grow at a constant annual rate of (1) -5% (2) 0% (3) 5% (4) 10% ?

b) 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% (2) 20% ? Are these reasonable result ? Explain.

c) Is it reasonable to think that a constant growth stock could have g>rs ? Explain.

Explanation / Answer

a.

P0 = D0(1+g)/r-g

P0 = $2(1+(-.05)/0.15 - (-.05) = $9.5

P0 = $2(1+0)/0.15 -0 = $13.33

P0 = $2(1+.05)/0.15 - .05 = $21

P0 = $2(1+.10)/0.15 - 0.10 = $44

b.

P0 = D0(1+g)/r-g

P0 = $2(1+.15)/0.15 - 0.15 = Infinity

P0 = $2(1+.20)/.15 -.20 = -$48

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