Investors require a 17% rate of return on Levine Company\'s stock (that is, rs =

Question

Investors require a 17% rate of return on Levine Company's stock (that is, rs = 17%).

What is its value if the previous dividend was D0 = $1.25 and investors expect dividends to grow at a constant annual rate of (1) - 3%, (2) 0%, (3) 4%, or (4) 10%? Round answers to the nearest hundredth.
a.
b.
c.
d.

2.) Using data from part a, calculate the Gordon (constant growth) model's value for Brooks Sisters stock if the required rate of return is 17% and the expected growth rate is (1) 17% or (2) 23%. Are these reasonable results? Explain.

3.) Is it reasonable to expect that a constant growth stock would ahve g> rs?

Explanation / Answer

Investors require a 17% rate of return on Levine Company's stock (that is, rs = 17%).

What is its value if the previous dividend was D0 = $1.25 and investors expect dividends to grow at a constant annual rate of (1) - 3%, (2) 0%, (3) 4%, or (4) 10%? Round answers to the nearest hundredth.
a. Value = D1/(rs-g)

Value = 1.25*(1-3%)/(17%+3%)

Value = $ 6.06

b.Value = D1/(rs-g)

Value = 1.25*(1+0%)/(17%-0%)

Value = $ 7.35

c.Value = D1/(rs-g)

Value = 1.25*(1+4%)/(17%-4%)

Value = $ 10.00

d.Value = D1/(rs-g)

Value = 1.25*(1+10%)/(17%-10%)

Value = $ 19.64

2.) Using data from part a, calculate the Gordon (constant growth) model's value for Brooks Sisters stock if the required rate of return is 17% and the expected growth rate is (1) 17% or (2) 23%. Are these reasonable results? Explain.

1) Value = D1/(rs-g)

Value = 1.25*(1+17%)/(17%-17%)

Value = infinity

2) Value = D1/(rs-g)

Value = 1.25*(1+23%)/(17%-23%)

Value = - $ 25.63

These results are not reasonable because assuming thatv IRR and cost of capital are constant ,which underlie the model.Thus, to get meaniful value of the share the value of growth rate (g)should be less than K or rs.While the Gordon Growth Model assumes that the earnings growth is constant for perpetuity, in practice this would be difficult for a company to achieve. Most analysts assume that a high growth rate can be sustained for only a limited number of years, followed by a sustainable rate of growth.

3.) Is it reasonable to expect that a constant growth stock would have g> rs?

Yes it is reasonable to expect that a constant growth stock would have g> rs

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