The stock of Constagrow pays dividends that are expected to grow at a steady rate of 3.2% per year. Investors expect a rate of return of 11.5% from Constagrow stock. If the spread between this required rate of return and the dividend growth rate were to increase by 50 basis points, the percentage change in the stock price would be:
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A. B. C. D.Explanation
In the usual notation, the Dividend Discount Model gives Po = D1/(k-g). When k - g = 11.5% - 3.2% = 8.3%, the price is given by Po = D1/0.083. When the spread increases by 50 basis points and all else stays constant, the price becomes P1 = D1/(0.083 + 0.005) = D1/0.088. The percentage change in the price equals (P1 -
Po)/Po = (1/0.088 - 1/0.083)*0.083 = 8.3/8.8 - 1 = -5.68%. Thus, the stock price falls by 5.68% when the spread between k and g increases by 50 basis points, all else equal.