Valuation of a constant growth stock Investors require a 17% rate of return on L
ID: 2786459 • Letter: V
Question
Valuation of a constant growth stock
Investors require a 17% rate of return on Levine Company's stock (i.e., rs = 17%).
What is its value if the previous dividend was D0 = $2.25 and investors expect dividends to grow at a constant annual rate of (1) -7%, (2) 0%, (3) 7%, or (4) 14%? 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 were (1) 15% or (2) 20%? Are these reasonable results? (select correct one below)
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.
The 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.
The 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.
The results show that the formula makes sense if the required rate of return is equal to or less than the expected growth rate.
The results show that the formula makes sense if the required rate of return is equal to or greater than the expected growth rate.
Is it reasonable to think that a constant growth stock could have g > rs? (SELECT CORRECT ANSWER BELOW )
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.
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.
Explanation / Answer
P = D*(1+g) / (r-g)
P1 = 2.25*(1-7%) / (17% + 7%) = 8.719
P2 = 2.25*(1+0%) / (17% + 0%) = 13.235
P3 = 2.25*(1+7%) / (17% - 7%) = 24.075
P4 = 2.25*(1+14%) / (17% -14%) = 85.5
b)
The 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. (Option B)
if r < g, it gives Negative share price
c)
It is not reasonable for a firm to grow indefinitely at a rate higher than its required return. (Option E)
Firms once matured cant grow more than required, normally we assume they grow at country's GDP growth
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