LED Corp.'s common stock paid $2.50 in dividends last year (D0).Dividends are expected to grow at a 12-percent annual rate forever.If LED's current market price is $40.00,and your required rate of return is 23 percent,should you purchase the stock?

Question

Quizplus · Accepted Answer

The stock's value can be calculated using the Gordon Growth Model (Dividend Discount Model for a perpetually growing dividend), which is P = D1 / (r - g), where P is the price, D1 is the dividend next year, r is the required rate of return, and g is the growth rate. Here, D1 = D0 * (1 + g) = $2.50 * (1 + 0.12) = $2.80, r = 0.23, and g = 0.12. Plugging these into the formula gives P = $2.80 / (0.23 - 0.12) = $2.80 / 0.11 = $25.45. Since the current market price of $40.00 is higher than the calculated value of $25.45, the stock is overpriced.

LED Corp'S Common Stock Paid $2