A:

First, a quick review: the required rate of return is defined as the return, expressed as a percentage, that an investor needs to receive on an investment in order to purchase an underlying security. For example, if an investor is looking for a return of 7% on an investment, then she would be willing to invest in, say, a T-bill that pays a 7% return or higher.

But what happens when an investor's required rate of return increases, such as from 7% to 9%? The investor will no longer be willing to invest in a T-bill with a return of 7% and will have to invest in something else, like a bond with a return of 9%. But in terms of the dividend discount model (also known as the Gordon growth model), what does the required rate of return do to the price of a security?

The required rate of return will adjust the price that an investor is willing to pay for a given security. For example, let's assume the following: an investor has a required rate of return of 10%; the assumed growth rate of dividends for a firm is 3% indefinitely (a very large assumption in itself); and the current dividend payment is $2.50 per year. According to the Gordon growth model, the maximum price the investor should pay is $35.71 ($2.50/(0.1 - 0.03)). As the investor changes her required rate of return, the maximum price she is willing to pay for a security will also change. For example, if we assume the same data as before but we change the required rate of return to only 8%, the maximum price the investor would pay in this scenario is $50 ($2.50/(0.08 - 0.03)).

This example just looks at the actions of a single investor. What would happen to stock prices if all investors changed their required rates of return?

A market-wide change in the required rate of return would spark changes in the price of a security. Take the second example given above (the reduction to 8% in the required rate of return): if all investors in a market reduced their required rate of return, they would be willing to pay more for a security than before. In such a scenario, security prices would be driven upward until the price became too high for the remaining investors to purchase the security. Should the required rate of return increase instead of decrease, the opposite would hold true.

To learn more, see Digging Into The Dividend Discount Model and How And Why Do Companies Pay Dividends?

RELATED FAQS
  1. How do you calculate working capital?

    Working capital represents the difference between a firm’s current assets and current liabilities. The challenge can be determining ... Read Full Answer >>
  2. Do you discount working capital in net present value (NPV)?

    Net present value (NPV) calculations should include the discounted value of changes in working capital. This treatment of ... Read Full Answer >>
  3. How is working capital different from fixed capital?

    There are several key differences between working capital and fixed capital. Most importantly, these two forms of capital ... Read Full Answer >>
  4. How much working capital does a small business need?

    The amount of working capital a small business needs to run smoothly depends largely on the type of business, its operating ... Read Full Answer >>
  5. What does high working capital say about a company's financial prospects?

    If a company has high working capital, it has more than enough liquid funds to meet its short-term obligations. Working capital, ... Read Full Answer >>
  6. What can working capital be used for?

    Working capital is used to cover all of a company's short-term expenses, including inventory, payments on short-term debt ... Read Full Answer >>
Related Articles
  1. Economics

    Financial Leverage In Corporate Capital Structure

    Corporate management uses financial leverage to increase earnings per share and return-on-equity.
  2. Economics

    What Happens in a Make-or-Buy Decision?

    A make-or-buy decision happens when a company must choose to either manufacture an item itself, or buy it premade from a supplier.
  3. Technical Indicators

    Key Financial Ratios to Analyze Investment Banks

    Find out which financial ratios are most useful when analyzing an investment bank, and why tracking capital efficiency is especially important.
  4. Fundamental Analysis

    Understanding the Internal Rate of Return Rule

    The internal rate of return rule is a popular method used to compare investments or projects.
  5. Term

    How Equity Capital Markets Work

    An equity capital market is a market existing between companies and financial institutions that raises money for the companies.
  6. Economics

    How to Do a Cost-Benefit Analysis

    The benefits of a given situation or business-related action are summed and then the costs associated with taking that action are subtracted.
  7. Economics

    Modified Internal Rate of Return (MIRR)

    Modified internal rate of return (MIRR) is a variant of the more traditional internal rate of return calculation.
  8. Fundamental Analysis

    Understanding the Capital Adequacy Ratio

    The capital adequacy ratio (CAR) is an international standard that measures a bank’s risk of insolvency from excessive losses. Currently, the minimum acceptable ratio is 8%. Maintaining an acceptable ...
  9. Investing

    Additional Paid-In Capital

    Additional paid-in capital is an account in the equity section of a balance sheet. It represents the additional amount paid for the company’s shares over the par value of the shares. Additional ...
  10. Fundamental Analysis

    Capital Budgeting

    Capital budgeting is a planning process used by companies to evaluate which large projects to invest in, and how to finance them. It is sometimes called “investment appraisal.”
RELATED TERMS
  1. IRR Rule

    A measure for evaluating whether to proceed with a project or ...
  2. Discounted Payback Period

    A capital budgeting procedure used to determine the profitability ...
  3. Cost Of Equity

    In financial theory, the return that stockholders require for ...
  4. Internal Rate Of Return - IRR

    A metric used in capital budgeting measuring the profitability ...
  5. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present ...
  6. Cost Test

    A standard test applied to a process to determine if the net ...
Hot Definitions
  1. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  2. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  3. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  4. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  5. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
Trading Center