Question

A share of common stock has just paid a dividend of $2.00. If the expected long-run growth rate for this stock is 5.00%, and if investors’ required return is 10.50%, what is the current stock price (round your answer to two decimal places)? (i) Describe and interpret the assumptions related to the problem. (ii) Apply the appropriate mathematical model to solve the problem. (iii) Calculate the correct solution to the problem.

Answer 1

Given: D0 =$2.00, growth rate g =5%,required rate of return r =10.5%

By dividend discout model , share price is given by

P = D0 (1+g) / (r-g) = 2*(1+0.05) / (0.105-0.05) = 38.18

So current stock price is $ 38.18

i) DDM assumes that stock price is based on return on investment it provides throuh dividends

ii) It assumes that dividends will be provided forever which may not be true in all cases

iii) It assumes that dividends grows at a constant rate while in reality that is not the case

iv) It assumes that investor's rate of return is known and constant. However it changes given the risk associated with the stock