Question

11. The current market price of a share of common stock is $67.50. The cash dividend...

11. The current market price of a share of common stock is $67.50. The cash dividend paid now is $5 [ D0 ]. The dividends are expected to grow at a constant rate of 8% per year for ever. The required rate of return on the common stock is 16%. Then the following is true according to the constant dividend growth model:

    a. the stock is underpriced   b. the stock is overpriced   c. the stock is correctly priced

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Answer #1
Required Rate of Return ( Ke)= 16.00%
Dividend Paid (Do)= $ 5
Growth rate (g)= 8.00%
According to Constant dividend growth model:
Fair Price of Share (Po)= Do ( 1+g) /(ke-g)
Fair Price of Share (Po)= $ 5 ( 1+ 0.08)/(0.16 - 0.08)
Fair Price of Share (Po)= $ 5.40 / 0.08
Fair Price of Share (Po)= $ 67.50
Current Market Price of Share= $ 67.50
Since Current Market price of share is equal to the fair price of share as calculated, thus
the stock is correctly priced
Therefore answer would be c. i.e. the stock is correctly priced.
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