Question

In the constant growth model, if the stable growth rate of the dividends of a firm is higher than its cost of equity, the intrinsic value of its shares must be negative.

a) True

b) False

Answer 1

The intrinsic value of shares is computed using the dividend discount model.

Price of the stock today=D1/(r-g)

where:

D1=next dividend payment

r=cost of equity

g=firm’s expected growth rate

The cost of equity must be greater than the growth rate for the intrinsic value of the shares to be positive.

If the cost of equity is less than the growth rate, the intrinsic value of shares is negative. Also, if the cost of equity is equal to the growth rate, the value per share approaches infinity.

Therefore, the statement is false