Question

The constant growth valuation formula has dividends in the numerator. Dividends are divided by the difference between the required return and dividend growth rate as follows:

Pˆ0P̂0

= =

D1(rs − gL)D1rs − gL

Which of the following statements is true?

Increasing dividends may not always increase the stock price, because less earnings may be invested back into the firm and that impedes growth.

Increasing dividends will always decrease the stock price, because the firm is depleting internal funding resources.

Increasing dividends will always increase the stock price.

Walter Utilities is a dividend-paying company and is expected to pay an annual dividend of $2.05 at the end of the year. Its dividend is expected to grow at a constant rate of 6.50% per year. If Walter’s stock currently trades for $12.00 per share, what is the expected rate of return?

6.66%

19.68%

23.58%

7.78%

Which of the following conditions must hold true for the constant growth valuation formula to be useful and give meaningful results?

The company’s stock cannot be a zero growth stock.

The company’s growth rate needs to change as the company matures.

The required rate of return, rss, must be greater than the long-run growth rate.

Answer 1

Ans - Part (A) Increase in dividend may not always increase the price . Take the example of mature company. The net profit declines as company is entering into mature phase. Lower net profits, lower dividend rate.

Part(B) Price = D₁ / (r- g)

where D₁₌ D₀ * ( 1 + g)

12 = 2.05 / r - 6.5%

12 = 2.05 / r - 6.5%

r - 6.5% = 2.05 / 12

r - 6.5% = 0.17083

or

r - 6.5% = 17.08%

r = 17.08% + 6.5%

r = 23.58%

PART (C) the required rate of return is always greater than growth, The reason behind that if r<g , then share price become negative

example- expected dividend = 2

rate =3%

g =4%

price = D₁ / (r- g)

= 2 / (3% - 4%)

= 2 / (-1%)

= -200 which is not possible .

That is why r should be grater than g always