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LOS d: Calculate the value of a common stock using the Gordon growth model and explain the underlying assumptions. fficeffice" />

Q1. The value per share for Burton, Inc. is $32.00 using the Gordon Growth model. The company paid a dividend of $2.00 last year. The estimates used to calculate the value have changed. If the new required rate of return is 12.00% and expected growth rate in dividends is 6%, the value per share will increase by:

A)   4.17%.

B)   9.51%.

C)   10.42%.

Correct answer is C)         

The value per share using the new estimates is $35.33 = [$2.0(1.06) / 0.12 - 0.06)] and the percentage increase in the value per share will be 10.42% = [(35.33 - 32.00) / 32.00] × 100%.

 

Q2. Suppose the equity required rate of return is 10%, the dividend just paid is $1.00 and dividends are expected to grow at an annual rate of 6% forever. What is the expected price at the end of year 2?

A)   $28.09.

B)   $27.07.

C)   $29.78.

Correct answer is C)       

The terminal value is $29.78, and that is the price an investor should be willing to pay at the end of year 2. The correct answer is shown below.

Year	Dividend
1	$1.0600
2	$1.1236
3	$1.1910
V3:	$1.191/(0.10 – 0.06) = $29.78

 

Q3. A company reports January 1, 2002, retained earnings of $8,000,000, December 31, 2002, retained earnings of $10,000,000, and 2002 net income of $5,000,000. The company has 1,000,000 shares outstanding and dividends are expected to grow at a rate of 5% per year. What is the expected dividend at the end of 2003?

A)   $3.15.

B)   $3.00.

C)   $13.65.

Correct answer is A)

The first step is to determine 2002 dividends paid as ($8,000,000 + $5,000,000 ? 10,000,000) = $3,000,000. The next step is to find the dividend per share ($3,000,000 / 1,000,000 shares) = $3.00 per share. Applying the 5% growth rate, next year’s expected dividend is $3.15, or $3.00 × 1.05.

 

Q4. Jax, Inc., pays a current dividend of $0.52 and is projected to grow at 12%. If the required rate of return is 11%, what is the current value based on the Gordon growth model?

A)   $58.24.

B)   unable to determine value using Gordon model.

C)   $39.47.

Correct answer is B)

The Gordon growth model cannot be used if the growth rate exceeds the required rate of return.

 

Q5. A firm currently pays a dividend of $1.77, which is expected to grow at a rate of 4%. If the required return is 10%, what is the current value of the shares using the Gordon growth model?

A)   $30.68.

B)   $29.76.

C)   $29.50.

Correct answer is A)

The current value of the shares is $30.68:

V₀ = [$1.77(1 + 0.04)] / (0.10 – 0.04)] = $30.68

 

Q6. Jand, Inc., currently pays a dividend of $1.22, which is expected to grow at 5%. If the current value of Jand’s shares based on the Gordon model is $32.03, what is the required rate of return?

A)   9%.

B)   8%.

C)   7%.

Correct answer is A)

The required return is 9%: r = [$1.22(1 + 0.05) / $32.03] + 0.05 = 0.09 or 9%.

 

Q7. A firm's dividend per share in the most recent year is $4 and is expected to grow at 6% per year forever. If its shareholders require a return of 14%, the value of the firm's stock (per share) using the single-stage dividend discount model (DDM) is:

A)   $50.00.

B)   $53.00.

C)   $28.57.

Correct answer is B)

The value of the firm's stock is: $4 × [1.06 / (0.14 ? 0.06)] = $53.00

 

Q8. IAM, Inc. has a current stock price of $40.00 and expects to pay a dividend in one year of $1.80. The dividend is expected to grow at a constant rate of 6% annually. IAM has a beta of 0.95, the market is expected to return 11%, and the risk-free rate of interest is 4%. The expected stock price two years from today is closest to:

A)   $43.49.

B)   $41.03.

C)   $43.94.

Correct answer is A)