Question

Investors require an 8% rate of return on Mather Company’s stock (i.e., rs 5 8%). a. What is its value if the previous dividend was D0 5 $1.25 and investors expect divi- dends to grow at a constant annual rate of (1) 22%, (2) 0%, (3) 3%, or (4) 5%? b. Using data from part a, what would the Gordon (constant growth) model value be if the required rate of return was 8% and the expected growth rate was (1) 8% or (2) 12%? Are these reasonable results? Explain. c. Is it reasonable to think that a constant growth stock could have g . rs? Why or why not?

Answer 1

Answer:

1. 12.25

2. 15.625

3. 25.75

4. 43.75

Explanation:

Po = Do (1 + g) /( Ke - g)

(1) Po = Do (1 + g) /(Ke - g)

Where = Ke = 8% , g= -2%

Po = 1.25(1 - 2%) / ( 8% + 2%)

= 1.225 / 10%

= $12.25

(2). Po =  Do (1 + g) /( Ke - g)

Where = Ke = 8% , g= 0%

Po = 1.25(1 + 0) / ( 8% - 0)

= 1.25 / 8%

= $15.625

(3). Po =  Do (1 + g) /( Ke - g)

Where = Ke = 8% , g= 3%

Po = 1.25 (1 + 3%) / (8% - 3%)

= 1.2875 / 5%

= $25.75

(4) Po =  Do (1 + g) /( Ke - g)

Where = Ke = 8% , g= 5%

Po = 1.25 ( 1 + 5%) / (8% - 5%)

= 1.3125 / 3%

= $43.75