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The Constant Growth Model

December 14, 2020

The Constant Growth Model

Suppose that Steady State Electronics wins a major contract for its revolutionary computer chip. The very profitable contract will enable it to increase the growth rate of dividends from 5% to 6% without reducing the current dividend from the projected value of $4.00 per share. What will happen to the stock price? What will happen to future expected rates of return on the stock?

The stock price ought to increase in response to the good news about the contract, and indeed it does. The stock price rises from its original value of $57.14 to a post announcement price of

d/ k-g =$4.00/0.12-0.06=$66.67

Investors who are holding the stock when the good news about the contract is announced will receive a substantial windfall.

On the other hand, at the new price the expected rate of return on the stock is 12%, just as it was before the new contract was announced.

E(r) = D1/P0 + g = $4.00/$66.67 +0.06 = 0.12, or 12%

This result makes sense, of course. Once the news about the contract is reflected in the stock price, the expected rate of return will be consistent with the risk of the stock. Since the risk of the stock has not changed, neither should the expected rate of return.