Question

3.In the Gordon growth model, a decrease in the required rate of return on equity

D. increases the current stock price.

4. Using the Gordon growth formula, if D1 is $2.00, Ke is 12% or 0.12, and g is 10% or 0.10, then the current stock price is

C.$100

These are the actual answers here, but could anyone please explain why? I need an explanation to study.

Answer 1

3. The Gordon growth model formula is as follows:

P = D₁ /(r -g) ,

where P = current stock price

D₁  = Expected dividend next year

r = rate of return of the company

g = growth rate expected for dividends

Hence, if rate of return of a company decreases and everything else remains the same, the denominator in the formula decreases, and hence P shall increase.  So the decrease in the required rate of return on equity increases the current stock price..

4. Refer to formula above:

Price of the stock = $2/(0.12-0.10)

= $2/.02  

= $100