Question

What is the price of a constant growth stock at year 2 (P₂) that has a year 3 dividend (D₃) of $4, a growth rate (g) of 3%, and a rate of return (r_S) of 13%?

Group of answer choices

$50

$60

$40

$30

Answer 1

Option (c) is correct

As per Gordon model, share price is given by:

Share price = D1 / k -g

where, D1 is next years' dividend, k is the required rate of return  and g is the growth rate

As per the above formula, share price in year 2, P2 is given by:

Share price (P2) = D3 / k - g

where, D3 is dividend in year 3 = $4, k is the required rate of return = 13% and g is the growth rate = 3%

Putting the values in the above formula, we get,

Share price (P2) = $4 / 13% - 3%

Share price (P2) = $4 / 10% = $40