Asked by Carina Campos on Apr 29, 2024
Verified
You wish to earn a return of 12% on each of two stocks, A and B. Each of the stocks is expected to pay a dividend of $2 in the upcoming year. The expected growth rate of dividends is 9% for stock A and 10% for stock B. The intrinsic value of stock A
A) will be greater than the intrinsic value of stock B.
B) will be the same as the intrinsic value of stock B.
C) will be less than the intrinsic value of stock B.
D) will be the same or greater than the intrinsic value of stock B.
E) None of the options are correct.
Expected Growth Rate
The anticipated rate at which a company, asset, or economy is expected to grow in the future.
Rate of Return
The gain or loss of an investment over a specified period, expressed as a percentage of the investment’s cost.
Dividend
A payment made by a corporation to its shareholders, usually in the form of cash or stock, from its profits or reserves.
- Examine the connection between stock prices through the lens of stable and fluctuating dividend growth rates.
Verified Answer
BG
Brittany GroenMay 02, 2024
Final Answer :
C
Explanation :
The intrinsic value of a stock can be calculated using the Gordon Growth Model, which is given by Price=D1r−g \text{Price} = \frac{D_1}{r - g} Price=r−gD1 , where D1D_1D1 is the expected dividend next year, rrr is the required rate of return, and ggg is the growth rate of dividends. For stock A, the intrinsic value is 20.12−0.09=20.03=66.67 \frac{2}{0.12 - 0.09} = \frac{2}{0.03} = 66.67 0.12−0.092=0.032=66.67 , and for stock B, it is 20.12−0.10=20.02=100 \frac{2}{0.12 - 0.10} = \frac{2}{0.02} = 100 0.12−0.102=0.022=100 . Since the intrinsic value of stock A is less than the intrinsic value of stock B, the correct answer is that the intrinsic value of stock A will be less than the intrinsic value of stock B.
Learning Objectives
- Examine the connection between stock prices through the lens of stable and fluctuating dividend growth rates.