Question

Short Answers 1. (2 pts) What are the two assumptions when one applies the constant growth model to analyze stock prices? 2. (2 pts) HB Computer has just paid a dividend of $1 (DO) and the growth rate in dividend is expected to be 6% per year into the future. The company's required råte of return Ke is 12%. How much should investors pay for the growth of the company? (i.e., Estimate the value of growth for this company.)

Answer 1

1.

Assumptions of Constant growth model:

• Growth rate (g) is less than Required return(k) i.e k>g
• Growth rate is constant for foreseeable future

2.

Value of Growth opportunity can be computed with following equation:

$PVGO = \frac{D0*(1+g)}{k-g}-\frac{D0}{k}$

where,

PVGO = Present value of Growth opportunity

D0 = last dividend

k = required return

g = growth rate

$PVGO = \frac{1*(1+0.06)}{0.12-0.06}-\frac{1}{0.12}$

$PVGO = 17.66666-8.3333333$

$\bg_green \large PVGO = \$9.33$

Hope this will help, please do comment if you need any further explanation. Your feedback would be highly appreciated.