Question

All else equal, the value of stocks under the Constant Growth DDM will be tend to be lower if the risk-free rate increases. Group of answer choices True False

Answer 1

All else equal, the value of stocks under the Constant Growth DDM will be tend to be lower if the risk-free rate increases. Group of answer choices True False

Answer: True

Explanation:

When risk free rate increases, it will increase required rate of return which will reduce the value of the stock.

This can be explained will the following example;

Next year dividend = $10, growth rate = 5%, required rate before increase in risk free rate = 15% and required rate after increase in risk free rate = 20%

Formula for calculating stock price under constant growth model is as follows;

Stock price = Next year dividend ÷ (Required rate of return – Growth rate)

Stock price before increase in risk free rate

Stock price     = Next year dividend ÷ (Required rate of return – Growth rate)

                        = $10 ÷ (0.15 – 0.05)

                        = $100

Stock price after increase in risk free rate

Stock price     = Next year dividend ÷ (Required rate of return – Growth rate)

                        = $10 ÷ (0.20 – 0.05)

                        = $66.67

From the above example we can clearly see that when risk free rate increase, shock price will reduce.