Super Carpeting Inc. (SCI) just paid a dividend (D₀) of $2.88 per share, and its annual dividend is expected to grow at a constant rate (g) of 6.00% per year. If the required return (r s ) on SCI’s stock is 15.00%, then the intrinsic value of SCI’s shares is per share.

Which of the following statements is true about the constant growth model?

A. The constant growth model can be used if a stock's expected constant growth rate is less than its required return
B. The constant growth model can be used if a stock's expected constant growth rate is more than its required return.

The intrinsic value per share is $33.92

Statement A is true about the constant growth model.

A. The constant growth model can be used if a stock's expected constant growth rate is less than its required return

Explanation:

The fair value or the intrinsic value per share of a stock whose dividends grow by a constant rate forever can be calculated using the constant growth model of dividend discount model approach. This model values a stock based on the present value of the expected future dividends from the stock. The fair value today under this model is calculated as follows,

P0 = D0 * (1+g)  /  (r - g)

Where,

P0 = 2.88 * (1+0.06)  /  (0.15 - 0.06)

P0 = $33.92

The constant growth model can only be used when the sustainable or constant growth rate is less than the required rate of return because a growth rate which is higher than the required rate of return will provide a negative share price and the prices for shares can never be negative. Thus statement A is correct.

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