Asked by Taylyn Vences on Jun 21, 2024
Verified
You want to earn a return of 10% on each of two stocks, A and B. Each of the stocks is expected to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends is 6% for stock A and 5% for stock B. Using the constant-growth DDM, the intrinsic value of stock A ________.
A) will be higher than the intrinsic value of stock B
B) will be the same as the intrinsic value of stock B
C) will be less than the intrinsic value of stock B
D) The answer cannot be determined from the information given.
Constant-Growth DDM
A dividend discount model that assumes dividends grow at a constant rate indefinitely, used to estimate the value of a stock.
Dividend
A distribution of a portion of a company's earnings to its shareholders, typically in the form of cash or stock.
Growth Rate
The rate at which a company's earnings or revenue increases over a certain period, often used as a measure of a company's financial health and potential for future expansion.
- Analyze the effects of growth rates on dividends and their subsequent impact on stock valuation.
- Execute the Constant-Growth Dividend Discount Model to estimate a stock’s value during steady growth conditions.
Verified Answer
CK
Chand KalraJun 24, 2024
Final Answer :
A
Explanation :
Using the constant-growth DDM, we can calculate the intrinsic value of each stock using the formula:
Intrinsic Value = D / (r - g)
Where:
D = expected dividend = $4
r = required rate of return = 10% = 0.10
g = expected growth rate of dividends
For Stock A:
Intrinsic Value = $4 / (0.10 - 0.06) = $100
For Stock B:
Intrinsic Value = $4 / (0.10 - 0.05) = $80
Therefore, the intrinsic value of Stock A is higher than that of Stock B, and the best answer is A.
Intrinsic Value = D / (r - g)
Where:
D = expected dividend = $4
r = required rate of return = 10% = 0.10
g = expected growth rate of dividends
For Stock A:
Intrinsic Value = $4 / (0.10 - 0.06) = $100
For Stock B:
Intrinsic Value = $4 / (0.10 - 0.05) = $80
Therefore, the intrinsic value of Stock A is higher than that of Stock B, and the best answer is A.
Learning Objectives
- Analyze the effects of growth rates on dividends and their subsequent impact on stock valuation.
- Execute the Constant-Growth Dividend Discount Model to estimate a stock’s value during steady growth conditions.