Question

40. (LO 7.3) Investors demand a rate of return of 15 percent on Sweet Life Food Inc.'s common shares. These shares are currently trading at $20 per share. Dividend payout for the current year is expected to be $1 per share. a. What is the implied long-term growth rate that shareholders expect? b. If, because of a recession, the dividend growth rate is projected to be 0, what will be the new share value? c. Conversely, if, because of a booming economy, investors reassess their growth expectations to 15 percent per year, what will happen to the market price of Sweet Life Food's common shares?

Answer 1

1) Required rate of return = r = 15%

share price = p = 20

Dividend in the current year = D₀ = 1

a) Using dividend growth rate model formula

p = D₀(1+g) / (r-g)

20 = 1(1+g) / (0.15 -g)

20(0.15-g) = 1+g

3 - 20g = 1 + g

21g = 2

g = 2/21 = 9.52%

2) if g = 0%

then p = 1(1+0) / (0.15-g) = 6.67

3) if g = 15%

then p = 2(1+0.15) / (0.15 -0.15)

then the share price rapidly increases to huge value