Economics of Money, Banking and Financial Markets, The, Business School Edition (5th Edition) (What's New in Economics)
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Chapter 7, Problem 1LO
To determine

The price of the common stock

Concept Introduction:

The Common stock is the security which is issued by corporations to raise capital. Usually, people who purchase such securities are called stockholder. They are paid a dividend as income

Expert Solution & Answer
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Explanation of Solution

There are various models to determine the price of a common stock. These are as follows:

  1. The one-period valuation Model
  2. Under this model, the price of the stock is calculated only for a year period, i.e., an investor keeps a stock only for a year period.

    To value the stock today, the present discounted value of the expected cash flow(future payment) is calculated. The cash flow consists of dividend payment and sale price.

      P0=D1(1+ke)+P1(1+ke)

    where

    D1= dividend given by the corporation at the end of the year

    P0= Current value of the stock P1= the expected sales price of the stock

    Ke= The required return on equity

  3. The Generalized Dividend Valuation Model
  4. Under this model, the price of a stock is calculated for n-number of periods. The value of a stock today is the present value of the future cash flows. The only cash flow is a dividend and a final sales price when the stock is ultimately sold after n-period.
      Economics of Money, Banking and Financial Markets, The, Business School Edition (5th Edition) (What's New in Economics), Chapter 7, Problem 1LO , additional homework tip  1

    where

    Dn= dividend given by the corporation at the end of n periods

    P0= current price of a stock

    Pn= Price of stock after n-periods

    Ke= the required return on equity

  5. The Gorden-Growth Model
  6. This model estimated the price of the stock when corporations strive to give regular dividend at regular interval of time.

      Economics of Money, Banking and Financial Markets, The, Business School Edition (5th Edition) (What's New in Economics), Chapter 7, Problem 1LO , additional homework tip  2

    D0=the most recent dividend paid

    G= the expected constant growth rate in dividends

    Ke=the required return on an investment in equity

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