Question

15. Suppose that the total value of dividends to be paid by companies in the Narnian stock market index is $100 billion. Investors expect dividends to grow over the long term by 5% annually, and they require a 10% return. Now a collapse in the economy leads investors to revise their growth estimate down to 4%. By how much should market values change?

a. -16.67%

b. zero

c. -20%

d. 20%

Answer 1

Given about a stock,

expected dividend D1 = $100 billion

growth rate g = 5%

required return rs = 105

Based on the data, using constant dividend growth rate to calculate its market values

Market value = D1/(rs - g) = 100/(0.10-0.05) = $2000 billion

If growth rate changes to 4%

New market value = 100 / (0.10 - 0.04) = $1666.67 billion

So, change in market value = (new market value - old market value)/old market value = (1666.67 - 2000)/2000 = -16.67%

Option a is correct.