Answer & Explanation:
(a) Gordon growth model:
Gordon growth model is a type of dividend discount model in which not only the dividends are factored in and discounted but also a growth rate for the dividends is factored in and the stock price is calculated based on that.
Formula:
P = D1 / (r − g)
where:
P = Current stock price
g = Constant growth rate expected for
dividends, in perpetuity
r = expected return in the stock
D1 = Value of next year’s dividends
As House of Haddock has 5,000 shares outstanding and the stock price is $140 and the company is expected to pay a dividend of $20 per share next year and thereafter the dividend is expected to grow indefinitely by 5% a year.
Therefore by putting the values in the above formula, we get
140 = 20 / ( r - .05 )
r = .192857
As the stock price is $140
So total value of the company = 140 * 5,000
total value of the company = 700,000
If the dividend growth rate is cut to 2.5%
P = 20/(.192857-.025)
P (one share) = 119.14
So the total value of the company becomes 595,745.
(b)
The expected stream of dividends per share for an investor who plans to retain his shares rather than sell them back to the company can be found be multiplying the previous dividend per share with 1.025
Expected stream of dividends per share = 20 * 1.025
= 20.5
Expected stream of dividends per share = 20.5 * 1.025
= 21.01
Expected stream of dividends per share for an investor = 20, 20.50, 21.01, 21,54 and so on.
