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To find out the stock's value with the information provided, the Gordon Growth Model would be used. The Gordon Growth Model is used to determine the price of a stock if the dividend, dividend growth rate and discount rate are all known. The underlying assumption behind the Gordon Growth Model is that the stock price is based on the expected future dividends -- investors are only investing for the known future cash flows. As a result, only the dividend and the discount rate are taken into account, along with the expected future growth rate of the dividend. Capital gains are not taken into account in the Gordon Growth Model.
The formula for the Gordon Growth Model is as follows:
Source: Investopedia (2011)
Thus, $2 / (.15-.05) = P
P = $
The stock's value if the riskiness of the stock changes would be calculated with the same formula, changing k to reflect the new risk level of the stock:
Thus, $2 / (.13-.05) = P
P = $
The stock's value if the growth rate of the dividend changes would be calculated with the same formula, changing G. To reflect the new level of dividend growth:
Thus, $2 / (.15 - .07) = P
P = $25
4. The cost of money is affected by a number of different factors. Production opportunities are one key factor in the cost of money. In an environment characterizes by slumping demand, such as the U.S. In the past few years, the demand for money will decrease. This is because firms do not feel that there are as many opportunities that will pay off. Lenders must lower rates in order to stimulate borrowing, by bringing more projects to a level where they will have a positive net present value. Conversely, if the economy is experiencing a period of strong growth and there are a lot of investment opportunities, the cost of money will be higher. Basically, the supply of money might not be high enough to meet the demand for it -- the Federal Reserve will usually restrict supply so that the economy does not become overheated -- and this drives the cost of money upward because so many companies are demanding money and there is competition among them to attract the attention of lenders with their returns.
Time preference for consumption is also a factor in the cost of money. A preference for longer-term consumption will increase long-term rates, but if the preference is for short-term consumption then it is short-term rates that will increase. Thus, a change in the time preference of consumption is going to result in a change in the cost of money at some point along the yield curve, but this change is not going to be universal across the yield curve. This leads to situations such as inverted yield curves that signal a pending recession (Amadeo, 2012).
Another factor in the cost of money is risk. Chmielowiec and Granger (2011) point out that the riskier an investment, the higher the cost of money associated with that investment will be. The reason for this is simple. An investor will choose, if all other factors are equal, the less risky of two investments. So in order to convince an investor to choose a riskier investment over a safer one, the riskier investment will need to pay a higher rate. The same is true with lenders. A bank will lend to a safer customer at a lower rate, and a risker customer at a higher rate. Without the higher rate, the riskier customer would not be able to receive credit. Thus, it is because of investor rationality that risk is a contributing factor in the price of money.
The fourth factor in the cost of money is inflation, or the expectation thereof. Simply put, a dollar today is worth more than a dollar tomorrow. That dollar tomorrow will buy less than the dollar of today because of inflation. Thus, the rate of inflation contributes to the time value of money, which is related to the cost of money (Sherrick, Ellinger & Lins, 2000). What this means is that when a bank lends money, they want the money that they receive back in the future to be the same value, plus the spread that they earn. The higher the inflation rate, the more the customer has to pay to ensure that the bank earns the same amount back as…[continue]
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