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1
1.) Common stock valuation: Negative growth Ray Steel Company is a mature
manufacturing company. The company just paid a $5 dividend and management
wants to cut future dividends, reducing them by 2% each year indefinitely. If you
require an 8% return on this stock, how much will you pay for it?
2.) Common stock valuation: Constant growth Sweet Candy will pay a dividend of
$0.72 next year. The CEO of the company declared that the company will maintain
a constant growth rate of 7% per year every year from now on.
a. How much will you pay for the stock if your required return is 10%?
b. How much will you pay for the stock if your required return is 8%?
c. Based on your answer in parts a and b, give one disadvantage of the constant
growth model.
Expert Solution
1) Computation of Current Stock Price:
Current Stock Price = Next Year Dividend/(Required Rate of Return - Growth Rate)
= $5*(1-2%)/(8%-(-2%))
= $4.9/10%
Current Stock Price = $49
2) a) Computation of Current Stock Price if Required Rate of Return is 10%:
Current Stock Price = Next Year Dividend/(Required Rate of Return - Growth Rate)
= $0.72/(10%-7%)
= $0.72/3%
Current Stock Price = $24
b) Computation of Current Stock Price if Required Rate of Return is 8%:
Current Stock Price = Next Year Dividend/(Required Rate of Return - Growth Rate)
= $0.72/(8%-7%)
= $0.72/1%
Current Stock Price = $72
c) This model is based on the assumption that share price is highly sensitive to dividend growth rate and growth rate can not be exceeded from required rate of return which is not always true.
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