Question

You wish 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 intrinsic value of stock A __________. a. will be higher than the present value of stock B b. will be the same as the presents value of stock B c. will be less than the present value of stock B

Answer 1

Answer:

a. will be higher than the present value of stock B

Explanation:

Use the formula for dividend discount model (DDM) to calculate the price of each stock;

For Stock A

Price = Div1 /(r-g)

where Div 1 = next year's expected dividend

r = required rate of return

g = dividend growth rate

Price = 4 / (0.10- 0.06)

Price = $100

For Stock B

Price = Div1 /(r-g)

Price = 4 / (0.10 - 0.05)

Price = $80

Therefore, the intrinsic value of stock A  will be higher than the present value of stock B