Question

Super Carpeting Inc. (SCI) just paid a dividend (D₀) of $3.12 per share, and its annual dividend is expected to grow at a constant rate (g) of 6.50% per year. If the required return (rss) on SCI’s stock is 16.25%, then the intrinsic value of SCI’s shares is      per share.

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

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.

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.

Use the constant growth model to calculate the appropriate values to complete the following statements about Super Carpeting Inc.:

•	If SCI’s stock is in equilibrium, the current expected dividend yield on the stock will be   per share.
•	SCI’s expected stock price one year from today will be   per share.
•	If SCI’s stock is in equilibrium, the current expected capital gains yield on SCI’s stock will be    per share.

Answer 1

1). Intrinsic Value = [D0 * (1 + g)] / [r - g]

= [$3.12 * (1 + 0.065)] / [0.1625 - 0.065] = $3.3228 / 0.0975 = $34.08

2). 2nd option is correct.

As we look in the formula above, if r increases and g remains constant. Hence, denominator will be increased which will reduce the share value.

3-a). Expected Dividend Yield = D1 / P0 = $3.3228 / $34.08 = 0.0975, or 9.75%

3-b). Stock price in 1 year = Price now * (1 + g) = $34.08 * (1 + 0.065) = $36.2952

3-c). Expected Capital Gains Yield = Required Return - Expected Dividend Yield

= 16.25% - 9.75% = 6.50%