honeycfa

All else equal, if there is an increase in the required rate of return, a stock’s value as estimated by the constant growth dividend discount model (DDM) will:

A) increase or decrease, depending upon the relationship between ke and ROE.

B) increase.

C) decrease.

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If k_e increases, the spread between k_e and g widens (increasing the denominator), resulting in a lower valuation.

honeycfa

An analyst has gathered the following data for Webco, Inc:

• Retention = 40%
• ROE = 25%
• k = 14%

Using the infinite period, or constant growth, dividend discount model, calculate the price of Webco’s stock assuming that next years earnings will be $4.25.

A) $55.00.

B) $125.00.

C) $63.75.

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g = (ROE)(RR) = (0.25)(0.4) = 10%

V = D₁ / (k – g)

D₁ = 4.25 (1 ? 0.4) = 2.55

G = 0.10

K – g = 0.14 ? 0.10 = 0.04

V = 2.55 / 0.04 = 63.75

honeycfa

Using the constant growth dividend discount model to value a firm whose growth rate is greater than its required return on equity would result in a value that is:

A) finite but unknown.

B) negative.

C) infinite.

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For the constant growth DDM to work k must be greater than g.

honeycfa

The constant-growth dividend discount model would typically be most appropriate in valuing a stock of a:

A) moderate growth, "mature" company.

B) rapidly growing company.

C) new venture expected to retain all earnings for several years.

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Remember, the infinite period DDM has the following assumptions:

• The stock pays dividends and they grow at a constant rate.
• The constant growth rate, g, continues for an infinite period.
• k must be greater than g. If not, the math will not work.

If any one of these assumptions is not met, the model breaks down. The infinite period DDM doesn’t work with growth companies. Growth companies are firms that currently have the ability to earn rates of return on investments that are currently above their required rates of return. The infinite period DDM assumes the dividend stream grows at a constant rate forever while growth companies have high growth rates in the early years that level out at some future time. The high early or supernormal growth rates will also generally exceed the required rate of return. Since the assumptions (constant g and k > g) don’t hold, the infinite period DDM cannot be used to value growth companies.

honeycfa

Which of the following statements about the constant growth dividend discount model (DDM) is FALSE?

A) For the constant growth DDM to work, the growth rate must exceed the required return on equity.

B) The constant growth DDM is used primarily for stable mature stocks.

C) In the constant growth DDM dividends are assumed to grow at a constant rate forever.

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Dividends grow at constant rate forever.

Constant growth DDM is used for mature firms.

k must be greater than g.

honeycfa

A stock is expected to pay a dividend of $1.50 at the end of each of the next three years. At the end of three years the stock price is expected to be $25. The equity discount rate is 16 percent. What is the current stock price?

A) $19.39.

B) $24.92.

C) $17.18.

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The value of the stock today is the present value of the dividends and the expected stock price, discounted at the equity discount rate:
$1.50/1.16 + $1.50/1.16² + $1.50/1.16³ + $25.00/1.16³ = $19.39

honeycfa

Use the following information on Brown Partners, Inc. to compute the current stock price.

• Dividend just paid = $6.10

• Expected dividend growth rate = 4%

• Expected stock price in one year = $60

• Risk-free rate = 3%

• Equity risk premium = 12%

A) $59.55.

B) $57.70.

C) $57.48.

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The current stock price is equal to (D₁ + P₁) / (1 + k_e). D₁ equals $6.10(1.04) = $6.34. The equity discount rate is 3% + 12% = 15%. Therefore the current stock price is ($6.34 + $60)/(1.15) = $57.70

honeycfa

An investor is considering acquiring a common stock that he would like to hold for one year. He expects to receive both $1.50 in dividends and $26 from the sale of the stock at the end of the year. What is the maximum price he should pay for the stock today to earn a 15 percent return?

A) $27.30.

B) $23.91.

C) $24.11.

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By discounting the cash flows for one period at the required return of 15% we get: x = (26 + 1.50) / (1+.15)¹

(x)(1.15) = 26 + 1.50

x = 27.50 / 1.15

x = $23.91

honeycfa

Assume that a stock paid a dividend of $1.50 last year. Next year, an investor believes that the dividend will be 20% higher and that the stock will be selling for $50 at year-end. Assume a beta of 2.0, a risk-free rate of 6%, and an expected market return of 15%. What is the value of the stock?

A) $41.77.

B) $45.00.

C) $40.32.

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Using the Capital Asset Pricing Model, we can determine the discount rate equal to 0.06 + 2(0.15 – 0.06) = 0.24. The dividends next year are expected to be $1.50 × 1.2 = $1.80. The present value of the future stock price and the future dividend are determined by discounting the expected cash flows at the discount rate of 24%: (50 + 1.8) / 1.24 = $41.77.

honeycfa

The following data pertains to a common stock:

• It will pay no dividends for two years.
• The dividend three years from now is expected to be $1.
• Dividends are expected to grow at a 7% rate from that point onward.

If an investor requires a 17% return on this stock, what will they be willing to pay for this stock now?

A) $ 7.30.

B) $10.00.

C) $ 6.24.

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time line = $0 now; $0 in yr 1; $0 in yr 2; $1 in yr 3.
P₂ = D₃/(k - g) = 1/(.17 - .07) = $10
Note the math. The price is always one year before the dividend date.
Solve for the PV of $10 to be received in two years.
FV = 10; n = 2; i = 17; compute PV = $7.30