Using the constant growth model, an increase in the required rate of return from 19 to 17 percent combined with an increase in the growth rate from 11 to 9 percent would cause the price to
A) fall more than 2 percent.
B) fall less than 2 percent.
C) remain constant.
D) rise more than 2 percent.
E) rise less than 3 percent.

Question

Quizplus · Accepted Answer

According to the constant growth model, stock price is calculated as P = D / (r - g), where D is the dividend, r is the required rate of return, and g is the growth rate. If the required rate of return increases from 19 to 17 percent, the denominator of the equation (r - g) decreases, which should increase the stock price. Similarly, if the growth rate also increases from 11 to 9 percent, the numerator of the equation (D) also increases, which should increase the stock price further. However, since the decrease in the denominator is larger than the increase in the numerator, the net effect is a decrease in the stock price. The percentage change can be calculated using the formula [(new price - old price) / old price] * 100. Plugging in the numbers, we get [(1.11 / (0.19 - 0.11)) - (1.09 / (0.17 - 0.09))] / (1.09 / (0.17 - 0.09)) * 100 = -1.1%. Therefore, the stock price would fall less than 2 percent, making option B the correct choice.

Using the Constant Growth Model, an Increase in the Required