Question

Which of the following statements is true?

A) In order for the constant growth dividend model to properly value a firm's common stock, R must be greater than g.
B) From a practical perspective, the growth rate in the constant growth dividend model must be greater than the sum of the long-term rate of inflation and the long-term real growth rate of the economy.
C) In order for the constant growth dividend model to properly value a firm's common stock, g must be greater than R.
D) The constant growth dividend model can be used effectively to value the common shares of a mixed growth stock.

Answer 1

To properly value a firm's common stock using the constant growth dividend model, the growth rate (g) must be less than the required rate of return (R).

Step-by-step explanation:

To properly value a firm's common stock using the constant growth dividend model, the growth rate (g) must be less than the required rate of return (R), not greater. The constant growth dividend model is based on the assumption that the stock's price can be determined by projecting future dividends and discounting them at the required rate of return. If the growth rate is higher than the required rate of return, it would imply an infinite value for the stock, which is not realistic.

For example, let's say a firm's stock has a required rate of return of 10% (R) and a growth rate of 12% (g). Plugging these values into the constant growth dividend model equation, which is P = D / (R - g), would result in a negative value for the stock price. This clearly shows that the growth rate must be less than the required rate of return for the model to be valid.

Therefore, statement C) in the question is false. In order for the constant growth dividend model to properly value a firm's common stock, the growth rate (g) must be less than the required rate of return (R).