Which of the following statements is true about the constant growth model?

a. When using a constant growth model to analyze a stock, if an increase in the growth rate occurs while the required return remains the same, this will lead to an increased value of the stock.

b. When using a constant growth model to analyze a stock, if an increase in the growth rate occurs while the require return remains the same, this will lead to a decreased value of the stock.

Question

Bailee Ayers

Business

23 November, 20:02

Which of the following statements is true about the constant growth model?

a. When using a constant growth model to analyze a stock, if an increase in the growth rate occurs while the required return remains the same, this will lead to an increased value of the stock.

b. When using a constant growth model to analyze a stock, if an increase in the growth rate occurs while the require return remains the same, this will lead to a decreased value of the stock.

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Answers (1)

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Houston Walsh · Answer 1

The correct answer is b. When using a constant growth model to analyze a stock, if an increase in the growth rate occurs while the require return remains the same, this will lead to a decreased value of the stock.

Explanation:

Constant growth model of the dividend ("constant growth DDM") or Gordon model considers that if the dividend has a constant growth rate, the value of a share will be determined by the following expression:

V (0) = D (1) / K (e) - g

The above formula is derived from financial mathematics and is used to calculate the present value of a perpetual periodic income of an amount D (1), geometrically increasing at a rate g, and discounted at a type K. In our case, V (0) is the estimated value of a company, D (1) is the expected dividend of the following year, K is the cost of the company's own resources considered and g is its perpetual rate of dividend growth.