The common stock of Peachtree Paper, Inc., is currently selling for $40 a share. A dividend of $2.00 per share was just paid. You are estimating that this dividend will grow at a constant rate of 10%
(a) Using the constant growth DVM model, what is your required rate of return if $40 is a reasonable trading price? (Show all work.)
(b) If Peachtree Papers is a new company that produces a relatively unknown product, is the constant growth model a good valuation method for a potential investor to use? Justify your answer.
What will be an ideal response?
Answer:
(a) Required rate of return
r = [$2.00(1.10)/$40] + 0.10
r = 15.50%
(b) No, it is not. The constant growth DVM is suited only for mature companies with strong track records. It is unlikely that the firm can continue increasing their dividends by 10% annually over the long term.
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