Briefly set out the Gordon growth model formula for an asset\'s \"intrinsic\" va

Question

Briefly set out the Gordon growth model formula for an asset's "intrinsic" value (P*) Carefully explain how each of the variables in the Gordon growth model influence the value (P*) a) 18] b) Show formally what happens to the intrinsic value (P*) in the following two cases: (i) the rate of return becomes zero and (ii) when an asset ceases to pay dividends. Provide a clear economic explanation for both cases [10] c) How might the Gordon growth model be used to explain changes in frish commercial land prices over the last two decades? 17)

Explanation / Answer

A) The Gordon growth model:

Intrinsic value of stock: Dividend/(Rate of return - growth rate)

Where rate of return is the return required by the shareholders.

Growth rate is the predicted long term growth rate by which the dividends are expected to grow.

Dividend is the expected dividend that the company is expected to pay next year.

B) If rate of return becomes zero, then intrinsic value = Dividend/(-growth rate). So, the value becomes negative. Ideally it is not possible to have zero rate of return since investors would always require some rate of return for their investment.

When an asset ceases to pay dividends, intrinsic value = 0, then this formula wouldn't work. Since there is an inherent assumption in the formula that the company pays dividends.

C) Now, during the early years, the growth rate was high and required return was constant. So the value of assets I.e. land increased at higher rates. With the time passing by, the required return increased as the risk was increasing since the loan was taken by mostly high risky debtors. So, the required return increased, while the growth was slowing down. Hence the land prices or asset value started declining.

Related Questions

Navigate

• Browse (All)
• Browse B
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.