Question

The constant-growth dividend model will provide invalid solutions when:

Select one:

A. the growth rate of the share exceeds the required rate of return for the share.

B. the growth rate of the share is less than the required rate of return for the share.

C. the growth rate of the share equals the dividend yield for the share.

D. None of the above

A company has just paid its first dividend of $4.86. Next year's dividend is forecast to grow by 6 percent, followed by another 6 per cent growth in year two. From year three onwards dividends are expected to grow by 3.6 percent per annum, indefinitely. Investors require a rate of return of 15 percent p.a. for investments of this type. The current price of the share is (round to nearest cent)

Select one:

a. $46.13

b. $42.00

c. $22.50

d. $24.47

Each quarter, a company pays a dividend on its perpetual preference share. Today, the share is selling at $16.89. If the required rate of return for such shares is 10.7 percent p.a. compounding quarterly, what is the quarterly dividend paid by this company? (to the nearest cent; don’t include $ sign)

Answer 1

	Year 1	Year 2	Year 3
Growth Rate	6%	6%	3.60%
Dividend	5.15	5.46	5.66

Now, on year 3 onward growth rate remains constant, so calculate the price of share at the year end Year 2;

P = D (1 + g) / (Ke – g)

    = 5.46 ( 1 + 0.036) / (0.15 – 0.036)

     = 5.66 / 0.114 = 49.64

Now, discount the dividend of year 1, year2 and terminal value of year 2 @ 15%

Current Price = 5.15/(1.15) + 5.46/(1.15)^2 + 49.64/(1.15)^2

                         = 4.48 + 4.13 + 37.53

Current Price = $46.14

Hence, Option A is correct.

Answer-2:

The Constant-growth dividend model will provide invalid solution when the growth rate of the share exceeds the required rate of return for the share.

Suppose, Dividend Paid = $10 per share

Constant Growth for Indefinite Period = 14%

Required rate of Return = 10%

Price = D (1 + g) / (Ke – g)

           = 10 (1 + 0.14) / (0.10 – 0.14)

           = 11.4 / -0.04

As the growth rate is more than required rate of return, therefore denominator becomes negative. It will provide the negative price of share that is invalid.

Hence option A is correct.