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CS Executive · Corporate Accounting and Financial Management · Security Analysis

In the Gordon (constant growth) model, the intrinsic value of an equity share today is the expected dividend of the next year divided by which of the following?

The Gordon model values a share as next year's expected dividend divided by the required rate of return minus the constant growth rate. The model needs the required return to exceed growth, otherwise the value is meaningless or negative.

  1. ARequired rate of return minus growth rateCorrect
  2. BRequired rate of return plus growth rate
  3. CGrowth rate minus required rate of return
  4. DRequired rate of return multiplied by growth rate

Explanation

Under the constant growth model, P0 = D1 / (ke - g). The denominator is the excess of the required return over the growth rate, and the model works only when ke exceeds g. Adding the two rates is a sign error and gives a wrongly low value.

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