The Northern Steak Co. pays an annual dividend of $2 per share on its common stock. This dividend...

Question:

The Northern Steak Co. pays an annual dividend of $2 per share on its common stock. This dividend amount has been constant for the past ten years and is expected to remain constant.

Given this, one share of the firm's stock:

a. is basically worthless as it offers no growth potential.

b. has a market value equal to the present value of $2 paid one year from today.

c. is valued as if the dividend paid is a perpetuity.

d. is valued with an assumed growth rate of 1%.

e. has a market value of $2 a share.

Dividend Growth Model:

When companies have ample cash buffer and robust operating cash flows, they prefer to reward investors through dividends or share repurchase. Companies that pay regular dividends can be valued using the dividend growth model. Other commonly used valuation measures include discounted cash flow valuation and PE based peer valuation.

Answer and Explanation:

.

The correct answer is -

  • Option (C) Is valued as if the dividend paid is a perpetuity.

Explanation -

  • Since the dividend is expected to remain constant in the coming years and since the business is a going concern, the company is valued as if the dividend is a perpetuity. The stock price using the dividend growth model is calculated as follows -
  • Stock Price = {eq}Do * ( 1 + G) / ( K - G ) {/eq}

Since there is no growth, the formula can be written as -

  • Stock Price = {eq}Do / K {/eq}

Therefore, once we have the required return (K), the stock price can be calculated.


Learn more about this topic:

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The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
10K

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