The cost of capital for common stock is ke=(D1/Po)+g. What are the assumptions of the model?
A. growth (g) is constant to infinity
B. the price earnings ration stays the same
C. the firm must pay a dividend to use this model
D. all of the above are assumptions of the model
The expected rate of return on a growth stock has two constants.
1. the expected divided yield and
2. the growth rate
so A and B are correct and A and B cannot be possible without C, so the answer is D ......Is this correct???
No, that is not correct. Let's go through each option to determine the correct answer:
A. growth (g) is constant to infinity: This assumption states that the growth rate of the company's dividends will remain constant indefinitely. If this assumption is not met, then the formula ke=(D1/Po)+g would not accurately calculate the cost of capital. Therefore, this assumption is needed for the model to hold.
B. the price earnings ratio stays the same: This assumption implies that the market's assessment of the company's future prospects does not change over time. If the price-earnings ratio (P/E ratio) remains constant, it means that investors are willing to pay the same multiple for the company's earnings. Again, if this assumption is not met, the model would not accurately calculate the cost of capital.
C. the firm must pay a dividend to use this model: This assumption states that the company pays dividends to its shareholders. However, the formula ke=(D1/Po)+g can also be modified to include share repurchases or other forms of returning value to shareholders. So, it is not necessary for the company to pay dividends specifically to use this model.
Based on the explanations above, D is not the correct answer. The correct answer is actually A and B.
Yes, your answer is correct. The assumptions of the model are:
A. growth (g) is constant to infinity
B. the price earnings ratio stays the same
C. the firm must pay a dividend to use this model
These assumptions imply that the expected rate of return on a growth stock has two constants: the expected dividend yield (D1/Po) and the growth rate (g). Therefore, all of the options A, B, and C are assumptions of the model, and the correct answer is D.