Question

1. The preferred stock of Dragons Inc. pays a $1 dividend. What is the value of the stock if your required rate of return is 10 percent?
2. Mosser Corporation, Inc. paid a $4 dividend last year. At a constant growth rate of 6 percent, what is the value of the common stock if the investors require a 10 percent rate of return?
3. HomeNet Inc. paid a $3 last year and the stock is currently selling for $60. If investors require a 12% return on their investment from buying HomeNet stock, what growth rate would HomeNet have to provide the investors?
4. What are the limitations of the dividend discount model?
5. Preferred stock is often referred to as hybrid security because it has many characteristics of both common stock and bonds. What are the characteristics similar to common stocks; what are the characteristics similar to bonds? Explain.

Answer 1

1. Value of this Preferred stock =Dividend/Required Rate =1/10% =10

2. Value of common Stock =D0*(1+g)/(Required Rate-growth) =4*(1+6%)/(10%-6%) =106

3. As Per dividend discount model Price =D0*(1+g)/(Required Rate-g)
60 =3*(1+g)/(12%-g)
7.2-60g =3+3g
g =(7.2-3)/(60+3) =6.67%

4. Limitation of dividend discount model
1. It cannot be used to value companies who do not pay dividends.
2. It is difficult to predict future growth of dividends, hence estimation of price using dividend discount model becomes difficult.