In the valuation of common stock, the simple annuity and perpetuity formulas used in the valuation of bonds and preferred stock are not generally applicable because _____.
A) investors buy common stock for much different reasons than they buy bonds or preferred stock
B) returns accruing to common stock should never be capitalized (discounted) in order to determine a price
C) unlike bonds and preferred stock, common stock is a short-term investment
D) unlike payments on most bonds and preferred stock, common stock dividends are normally expected to grow over time

Question

Quizplus · Accepted Answer

Unlike payments on most bonds and preferred stock, common stock dividends are normally expected to grow over time. Therefore, the perpetuity formula (which assumes a constant payment stream) is not applicable for valuing common stock. Instead, the dividend discount model is used, which takes into account the expected growth rate of dividends. Choices A, B, and C are not accurate reasons for the lack of applicability of simple annuity and perpetuity formulas for common stock valuation.

In the Valuation of Common Stock, the Simple Annuity and Perpetuity