Question

According to the dividend growth model, the price of a share of stock increases when... (Choose all that apply)

I. The required rate of return decreases

II. The required rate of return increases

III. The dividend growth rate decreases

Answer 1

Correct answer is I. The required rate of return decreases

According to dividend growth model, the current price of a share of stock can be calculated with below formula-

where, Po is the current market price.
D1 = Dividend to be paid by company next year.
g = Growth rate
Ke = cost of equity/required rate of return

Hence, the price of the stock will increase either if numerator increases or demoninator decreases i.e the dividend payable next year increases or required rate of return decreases or Growth rate increases.

This can be proved with help of below expample-

Suppose, D1 = 2 $

Ke = 10 %

g = 5 %

According to dividend growth model,

Po = 2 / 0.10 - 0.05

= 40 $

Now suppose, Ke decreases to 8 %

Po= 2 / 0.08 - 0.05

=66.67 $

With the decrease in required rate of return price increases.

Hope it explains!