Question

Constant growth stocks

Super Carpeting Inc. just paid a dividend (D0D0) of $1.92, and its dividend is expected to grow at a constant rate (g) of 2.80% per year.
If the required return (rsrs) on Super’s stock is 7.00%, then the intrinsic, or theoretical market, value of Super’s shares is ($68.57, $48.91, $27.43, OR $46.90) per share.
Which of the following statements is true about the constant growth model?
A. When using a constant growth model to analyze a stock, if an increase in the required rate of return occurs while the growth rate remains the same, this will lead to an increased value of the stock.
B. When using a constant growth model to analyze a stock, if an increase in the required rate of return occurs while the growth rate remains the same, this will lead to a decreased value of the stock.

Answer 1

Using the Gordon Growth Model with given metrics, D0 = $1.92, g = 2.80%, and rs = 7.00%, we can determine the intrinsic value of Super Carpeting Inc.'s stock. An increased required rate of return results in a decreased stock value. Option B is the correct answer.

Step-by-step explanation:

The student has asked about the intrinsic value of Super Carpeting Inc.'s shares given certain financial metrics and a question related to the constant growth model used in stock analysis. To find the intrinsic value of Super Carpeting Inc.'s stock, we use the Gordon Growth Model, which is formulated as P0 = D1 / (rs - g), where P0 represents the current stock price, D1 is the dividend next year, rs is the required rate of return, and g is the dividend growth rate.

We calculate D1 as D0 * (1+g), where D0 is the most recent dividend paid. Given the following values: D0 = $1.92, g = 2.80%, and rs = 7.00%, we calculate the intrinsic value of the stock, which is not given in the original question.

Additionally, the student inquired about the effect of changes in the required rate of return on a stock's value within the context of the constant growth model. The correct statement is that when the required rate of return increases while the growth rate remains the same, this leads to a decreased value of the stock. This inverse relationship is important for investors to understand when evaluating potential investments.

The historical context of dividends and capital gains provided in the question background exemplifies the variability in returns from equity investments over time. It highlights the reducing trend in dividend yields over the decades and an increase in capital gains, particularly from the 1980s onward. Understanding these trends is essential for investors seeking to balance their portfolios and expectations for income versus appreciation in stock value.