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Which of the following assumptions does the constant-growth dividend discount model require?
a- Dividends grow at a constant rate
b- ROE and the plowback rate are constant
c- The required rate of return is less than the dividend growth rate |
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| 1. Theoretically, dividend discount models can be used to value the stock of rapidly growing companies that do not currently pay dividends; in this scenario, we would be valuing expected dividends in the relatively more distant future. However, as a practical matter, such estimates of payments to be made in the more distant future are notoriously inaccurate, rendering dividend discount models problematic for valuation of such companies; free cash flow models are more likely to be appropriate. At the other extreme, one would be more likely to choose a dividend discount model to value a mature firm paying a relatively stable dividend. |
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At Litchfield Chemical Corp. a director of the company said that the use of dividend discount models by investors is proof that the higher the dividend the higher the stock price
a using a constant growth model dividend discount model as a basis of reference, evaluate the directors statement |
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| 2. It is most important to use multi-stage dividend discount models when valuing companies with temporarily high growth rates. These companies tend to be companies in the early phases of their life cycles, when they have numerous opportunities for reinvestment, resulting in relatively rapid growth and relatively low dividends (or, in many cases, no dividends at all). As these firms mature, attractive investment opportunities are less numerous so that growth rates slow. |
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| 3. The intrinsic value of a share of stock is the individual investor’s assessment of the true worth of the stock. The market capitalization rate is the market consensus for the required rate of return for the stock. If the intrinsic value of the stock is equal to its price, then the market capitalization rate is equal to the expected rate of return. On the other hand, if the individual investor believes the stock is underpriced (i.e., intrinsic value < price), then that investor’s expected rate of return is greater than the market capitalization rate. |
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| 4. MV = 10 + 90 = 100 mil BV = 10 + 60 – 40 = 30 mil MV / BV = 100 / 30 = 3.33 |
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| 5. g = .6 x .10 = .06 price = 2 / (.08 - .06) = 100 P/E = 100 / 5 = 50 |
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| 6. k = .04 + .75 (.12-.04) = .10 Price = 4 / (.10 - .04) = 66.66 |
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7. Price with no growth = 6 / .10 = 60
g = .60 x .15 = .09
Price with growth = 2.40 / (.10 - .09) = 240
PVGO = 240 – 60 = 180 |
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300 EBIT
105 -Taxes
195 Net Income
20 + depreciation
60 - CapEx
30 - increase in WC
125 FCF |
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9.
FCFE = 205 – 22 x (1 - .35) + 3 = 193.70
Value = 193.70 / (.12 - .03) = $2,152.22 |
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| 10. P = $2.10/0.11 = $19.09 |
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