Question

Based on the dividend discount model, an increase in discount rate will lower the current value of a stock.

True or False

Under the dividend discount model, for the first few years, a company can have a growth rate that is higher than the discount rate.

True or False

7.0.1

Answer 1

The dividend discount model is :

Po = D1/ Re - g

Yes, it is true that an increase in the discount rate will lower the current value of a stock.

For example,

If, D1 = $2

Re = 10%

g = 5%

So, the value of the stock is :

= $2/ 0.05

=$40

If the discount rate increases to 11%,

= $2/ 0.06

=$33.33

So, the value of the stock falls. So, it is a TRUE statement.

Under the dividend discount model, the growth rate can never be more than the discount rate in the terminal year, as in that case it will provide a negative terminal value. In the initial stages of growth, the growth rate can be higher than the discount rate.

So, it is a true statement.