Question

Changes in Growth and Stock Valuation Consider a firm that had been priced using a 10.00 percent growth rate and a 14.00 percent required rate. The firm recently paid a $1.00 dividend. The firm has just announced that because of a new joint venture, it will likely grow at a 12.00 percent rate. How much should the stock price change (in dollars and percentage)?

Multiple Choice

• $28.50, 1.04%

• $28.50, 104.00%

• $25.00, 1.00%

• $25.00, 100.00%

Answer 1

According to the Constant growth Model,

P0 = D1 / ( Ke - G)

Where, P0 = Stock price

D1 = Dividend for year 1

Ke = Required return

G = Growth

D1 = D0 * ( 1 + G)

where, D0 is Current dividend

Price before announcement of Joint venture

P0 = 1 * ( 1 + 10%) / ( 14% - 10%)

= 1.1 / (4%)

= 1.1 / (0.04)

= $27.5

Price after the announcement

Growth rate = 12%

P0 = 1 * ( 1 + 12%) / (14% - 12%)

= 1.12 / (2%)

= $56

So, the change in Price = 56 - 27.5

= 28.5

Percentage change = [(56 - 27.5) / 27.5] * 100

= 103.6363 or 104% [Rounded off]

Option B is the correct answer