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You want to earn a return of 10% on each of two stocks, A and B. Each of the stocks is expected to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends is 6% for stock A and 5% for stock B. Using the constant-growth DDM, the value of stock A _________. A. will be higher than the value of stock B B. will be the same as the value of stock B C. will be less than the value of stock B D. The answer cannot be determined from the information given.

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Shahzaibfaraz

Answer:

The value of stock A is higher than the value of Stock B and option A is the correct answer.

Explanation:

The constant growth model values the intrinsic value of a stock based on a constant growth rate in the dividends paid by the stock. This is a part of DDM and it values a stock based on the present value of the expected future dividends from the stock.

The formula for price today under constant growth model is,

P0 = D1 / (r -  g)

Where,

  • D1 is the expected dividend for the next period
  • r is the required rate of return
  • g is the growth rate in dividends

We will calculate the P1 and discount is back one year to calculate the price today because we are given P1 and the constant growth rate applies from Year2 or D2.

Stock A

P1 = 4 * (1+0.06) / (0.1 - 0.06)

P0 = 106 / (1+0.1)

P0 = $96.36

Stock B

P1 = 4 * (1+0.05) / (0.1 - 0.05)

P0 = 84 / (1+0.1)

P0 = $76.36

Thus the value of stock A is higher than that of Stock B.

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