Question

Suppose that in 2020 the expected dividends of the stocks in a broad market index equaled $200 million when the discount rate is 7% and the expected growth rate of the dividends is 3%. Using the constant-growth formula for valuation, if interest rates decrease to 5%, the value of the market will change by

	A.	50%
	B.	50%
	C.	100%
	D.	-100%

Answer 1

Given,

Expected dividends = $200 million

Discount rate = 7% or 0.07

Growth rate = 3% or 0.03

New discount rate = 5% or 0.05

Solution :-

Current market value = expected dividends (discount rate - growth rate)

= $200 million (0.07 - 0.03)

= $200 million 0.04 = $5000 million

New market value = expected dividends (new discount rate - growth rate)

= $200 million (0.05 - 0.03)

= $200 million 0.02 = $10000 million

Change in market value = (new market value - current market value) current market value

= ($10000 million - $5000 million) $5000 million

= $5000 million $5000 million = 1 or 100%

Thus, option 'C' is correct.