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Hi John,
In the growth model, to get the Ke with dividend growth, the formula is D0(1+g)/Po + g.
T1 dividend (1+g) is a point in time as with T0 (1). It is just two static numbers for terminal value calculation. At the same price, T1/Po will be higher than T0/Po.
However, the dividend is growing and we need to account for it. Therefore, I understand why the growth needs to be added to the Ke (if price remains the same). e.g. T1/P0 + g
How can we proof this mathematically that the growth (say 6%) translate exactly to the Ke (e.g. T1/P0 + 6%)
You use an iterative proof.
If the rate of growth is g and the discount rate is Ke, then
Po = D(1+g)/(1+Ke) + D ((1+g)/(1+Ke))^2 and so on to infinity.
You multiply throughout by (1+g)/(1+Ke), and then solve the two equations together.
If you have studied this arithmetic before then it is a very easy proof. Otherwise do not waste your time because you cannot be asked to prove it which is why you are given the formula in the exam.
Thanks John. This is just for my own understanding. Really appreciate your help!
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