Constant Growth Valuation is a fundamental concept in finance. The value of the firm's stock is the present value of its expected future dividends. If Dt stands for dividend at period t and rs is the required rate of return, which is a riskless rate plus a risk premium, then the expected value of firm's stock is determined as follows: Value of stock, P0= PVof expected future dividends =(1+rs)1D1+(1+rs)2D2++(1+rs)D=t=1(1+rs)tDt For many companies it is reasonable to predict that dividends will grow at a constant rate, g. Thus, the previous equation may be rewritten as follows: P0=(1+rs)1D0(1+g)1+(1+rs)2D0(1+g)2++(1+rs)D0(1+g)=rsgD0(1+g)=rsgD1 If the stock is in equilibrium, rs must equal the expected dividend yield plus an expected capital gains yield. Thus, you can solve for an expected rate of return, rs : Expectedrateofreturn,rs=Expecteddividendyield+Expectedgrowthrate,orcapitalgainyield=P0D1+g Suppose that D0=$1.00 and the stock's last closing price is $26.25. It is expected that earnings and dividends will grow at a constant rate of g=5.00% per year and that the stock's price will grow at this same rate. Let us assume that the stock is fairly priced, that is, it is in equilibrium, and the most appropriate required rate of return is rs=9.00%. The dividend received in period 1 is D1=$1.00(1+0.0500)=$1.05 and the estimated intrinsic value in the same period is based on the constant growth model: P1=rsgD2. Using the same logic, compute the dividends, prices, and the present value of each of the dividends at the end of each period. The dividend yield for period 1 is The capital gain yield expected during period 1 is and it will and it will each period. each period. If it is forecasted that the total return equals 9.00% for the next 5 years, what is the forecasted total return out to infinity? 4.00% 5.00% 9.00% 14.00% Note that this stock is called a "Hold" as its forecasted intrinsic value is equal to its current price P0=rsgD1=0.09000.0500$1.05=$26.25 and the expected total return is equal to the required rate of return rs. If the market was more optimistic and the growth rate would be 6.00% rather than 5.00%, the stock's forecasted intrinsic value would be P0=0.09000.0600$1.05=$35.00, which is greater than $26.25. In this case, you would call the stock a "Buy". Suppose that the growth rate is expected to be 3.00%. In this case, the stock's forecasted intrinsic value would be its current price, and the stock would be a