An intern at Smith, Kleen, & Beetchnutty has recently been asked to value shares of Dynamic Impact, a multinational media conglomerate, using the Gordon
Model. Dynamic Impact is a stable firm which has experienced steady growth for much of the last twenty years, and this growth rate is not anticipated to change.
In his assignment, the intern has been provided with the following information:
Expected dividend at t5: $1.45 -
Required rate of return on equity: 14.25% per year
Growth rate of dividends: 10.00% per year
Using the information provided, what is the value of Dynamic Impact's common shares?
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A. B. C. D. E. F.B
Since the growth rate of dividends is not expected to change in the future, the Gordon Model can be applied. The Gordon Model is commonly referred to as the
"constant growth dividend discount model." This model of common stock valuation is illustrated as follows:
P0 = [D1 / (r - g)]
Where -
P0 = the price of common stock X at time 0
D1 = the expected dividend at t1
r = the required rate of return on equity investments and g = the expected growth rate of dividends.
Since we are not provided the dividend at t1, we must determine it manually be discounting the dividend at t5 by the growth rate of dividends. The determination of
D1 is as follows:
D1 = {D5 / [(1 + g)(1 + g)(1 + g)(1 + g)]}
D1 = {$1.45 / [1 + 0.10)(1 + 0.10)(1 + 0.10)(1 + 0.10)]}
D1 = {$1.45 / 1.1461} = $0.9904 -
Now that the dividend at t1 has been determined, the given information can be put into the equation provided, leading to the following series of calculations:
P0 = [$0.9904 / (0.1425 - 0.10)] = $23.30
This is illustrated by none of the answers provided.
When using the Gordon model, remember that the required rate of return "r" must be greater than the expected growth rate "g." Otherwise, this equation will produce a nonsensical answer.