Question

Super Carpeting Inc. (SCI) just paid a dividend (D₀) of $2.88 per share, and its annual dividend is expected to grow at a constant rate (g) of 6.00% per year. If the required return (r s ) on SCI’s stock is 15.00%, then the intrinsic value of SCI’s shares is _____ per share.

Which of the following statements is true about the constant growth model?

A. The constant growth model can be used if a stock's expected constant growth rate is less than its required return
B. The constant growth model can be used if a stock's expected constant growth rate is more than its required return.

Answer 1

The intrinsic value per share is $33.92

Statement A is true about the constant growth model.

A. The constant growth model can be used if a stock's expected constant growth rate is less than its required return

Step-by-step explanation:

The fair value or the intrinsic value per share of a stock whose dividends grow by a constant rate forever can be calculated using the constant growth model of dividend discount model approach. This model values a stock based on the present value of the expected future dividends from the stock. The fair value today under this model is calculated as follows,

P0 = D0 * (1+g) / (r - g)

Where,

• D0 * (1+g) is the dividend for the next period or D1
• r is the required rate of return
• g is the constant growth rate

P0 = 2.88 * (1+0.06) / (0.15 - 0.06)

P0 = $33.92

The constant growth model can only be used when the sustainable or constant growth rate is less than the required rate of return because a growth rate which is higher than the required rate of return will provide a negative share price and the prices for shares can never be negative. Thus statement A is correct.