Question #62
Reading: Reading 20 Discounted Dividend Valuation
PDF File: Reading 20 Discounted Dividend Valuation.pdf
Page: 24
Status: Correct
Correct Answer: A
Question
Zephraim Axelrod, CFA, is trying to determine whether Allegheny Mining is a good investment. He decides to use the Gordon Growth model to calculate how much dividend growth shareholders can expect. To that end, he determines the following: Share price: $18.12. Dividend: $0.32 per share. Beta: 1.94. Industry average estimated returns: 15%. Risk-free rate: 5.5%. Equity risk premium: 6.3% Based only on the information above, the implied dividend growth rate is closest to:
Answer Choices:
A. 19.89%
B. 15.68%
C. 10.27%
Explanation
We have the price and dividend. We need the required rate of return to use the Gordon
Growth model to calculate implied dividend growth. Using the capital asset pricing model,
the required return = risk-free rate + (beta × equity risk premium) = 17.72%.
Price = [dividend × (1 + dividend growth rate)] / [required return − growth rate]
18.12 = [0.32 × (1 + dividend growth rate)] / [0.1772 − dividend growth rate]
18.12 × [0.1772 − dividend growth rate] = 0.32 + 0.32 × dividend growth rate
3.2112 − 18.12 × dividend growth rate = 0.32 + 0.32 × dividend growth rate
2.8912 = 18.44 × dividend growth rate
1 = 6.3779 × dividend growth rate
Dividend growth rate = 15.68%