Which of the following statements is correct? a. The constant growth model takes into...

Question:

Which of the following statements is correct?

a. The constant growth model takes into consideration the capital gains investors expect to earn on a stock.

b. Two firms with the same expected dividend and growth rates must also have the same stock price.

c. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant.

d. If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of 5%, this implies that the stock%u2019s dividend yield is also 5%.

e. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate.

Constant Growth Dividend Discount Model:

This problem requires a general understanding of the constant growth dividend discount model, which is also referred to as the Gordon Growth Model. It is a widely used stock valuation model, which computes the fair value of a stock as the sum of all future dividends, discounted using an appropriate rate.

Answer and Explanation:

The formula for the dividend discount model (DDM) is provided below. To utilize it, the growth rate of a company's dividends must be assumed to be constant.

P0 = D1/(r-g)

Where,

P0 = intrinsic value of stock

D1 = dividend payment one year from today

r = discount rate

g = growth rate

Based on the information above, the correct answer is "a. The constant growth model takes into consideration the capital gains investors expect to earn on a stock." While capital gains are not explicitly expressed in the DDM, the model is reflective of the intrinsic value of a stock. All sources of value are embedded in the dividend and growth rate assumptions.


Learn more about this topic:

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The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
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