Question

Problem 5

5.1 Gordon’s model of equity valuation assumes k < g. (True / False)

5.2 High P/E multiple may indicate, all else equal:

              a. High growth

              b. Low systematic risk

              d. Overvaluation

              e. Any of the above

5.3 Under Gordon’s model of equity valuation, the same dividend amount is paid out in perpetuity. (True / False)

5.4 Retention ratio is the percentage of earnings that is paid out as dividends. (True / False)

5.5 Firm X is priced at $10 per share. Expected dividend next year is $1 per share, and the expected stock price next year is $11. Therefore, stock is expected to earn (11 + 1 – 10)/10 = 20%. This implies that the company has required rate of return that is also 20%. (True / False)

5.6 When ROE < k, increasing _______ should increase the intrinsic value of equity.

              a. Retention ratio

              b. Dividend payout

              c. Dividend growth rate

5.7 Present Value of Growth Opportunities PVGO can never be negative. (True / False)

5.8 Required rate of return on equity can be found from which formula?

              a. CAPM

              b. Gordon’s Model

              c. ROE

              d. Either of the above, depends on what information is provided

5.9 If the company is correctly priced under Gordon’s model, and changing dividend payout policy does not change stock price, it must be that

              a. ROE = k

              b. The company is a cash cow

              c. PVGO > 0

5.10 Growth in dividends can be represented as sustainable growth rate in Gordon’s model. (True / False)

Answer 1

5.1 False.

Reason: As per the assumptions of the Gordon Model growth rate (g) cannot exceed the investor’s required rate of return (k). If ‘g’ is greater than ‘k’ the result would be negative, and stock cannot have negative results.

5.2 e (Any of the above).

1st Condition: High Growth. In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E.

2^nd Condition: Lower Systematic Risk. A test of efficient market hypothesis states that returns on the stocks with low P/E ratio tend to be larger than warranted by the underlying risks. So Higher P/E ratio indicates lower Systematic Risk.

3^rd Condition: Over Valuation. Stock price and P/E ratio, Generally speaking, a high P/E ratio indicates that investors expect higher earnings. However, a stock with a high P/E ratio is not necessarily a better investment than one with a lower P/E ratio, as a high P/E ratio can indicate that the stock is being overvalued.

5.3 False.

Reason: As the name itself Gordon’s Growth Model indicates growth. In this model, the dividend is constantly growing not the same amount of dividend.

5.4 False.

Reason: The retention ratio refers to the percentage of net income that is retained to grow the business, rather than being paid out as dividends.