Question

Assume you are using the dividend growth model to value stocks. If you expect the inflation rate to increase, you should also expect: A. market value of all stocks to decrease, all else equal. B. market value of all stocks to remain constant as the dividend growth will offset the increase in inflation. C. stocks that do not pay dividends to decrease in price while dividend paying stocks maintain a constant price.

Answer 1

A

Step-by-step explanation:

the constant dividend growth model

price = d1 / (r - g)

d1 = next dividend to be paid

r = interest rate

g = growth rate

Interest rate used is usually nominal, thus, it increases with inflation rate

We can see that the interest rate is an inverse function of the value, thus when inflation increases, interest rate increases and price declines

Example

d1 = 5

r = 10%

g = 5%

5/ (0.1 - 0,05) = 100

when interest rate increases to 20% as a result of inflation, value becomes

5 / 0.2 - 0.05 = 33.33

value decreased with increase in inflation