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# Dividend Discount Model

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A relatively new firm has the dividend payment history shown in
Table 9-10. Suppose this stock sells for \$8 per share. Estimate the
shareholders' required rate of return using the dividend discount model
with the following:
a. The dividend growth rate calculated over the firm's entire history.
b. The growth rate calculated over the actual dividend paying history
only.
Why are the two answers different? Which do you think is most meaningful?
TABLE 9-10
Year Dividends Paid
2000 \$0
2001 0
2002 0
2003 0
2004 0.10
2005 0.13
2006 0.15
2007 0.18

#### Solution Preview

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Dividends over the Firm's Entire History
- First, to use the dividend discount model (DDM), several inputs are needed
- DDM formula:

Stock Value = Dividend Per Share Expected for the Next Year
Required rate of return - Dividend growth rate

Value = D / (k + g) where k is the required rate of return and g is the dividend growth rate

- The stock value is given - \$8
- The dividends expected in the following year can be calculated using the dividend growth rate - next year's dividend = this year's dividends * (1 + g)
- To calculate the average growth rate over the firm's entire history, we must add up all dividends paid and divide this total by the number of years the firm has been in operation

Average growth rate = ...

#### Solution Summary

The question provides the dividends paid over several years and asks for computations of shareholders' required rate of return using the dividend discount model (DDM) and two different assumptions regarding the dividend growth rate.

\$2.19

## The Dividend Discount Model and the CAPM

CAPM and Cost of Equity Estimation

1) What is your opinion to the questions below?

The Capital Asset Pricing Model (CAPM) is a linear model that can be used to estimate a company's cost of equity and determine a stock's required rate of return. The required rate of return is one input into the Dividend Discount Model, a model used to determine the value of a company's common stock. There are a several varieties of the Dividend Discount Model including the zero growth model, the constant growth model, and the differential growth model. An analyst needs to use his or her best judgment to determine which model variety should be used to value a company's common stock. For example, if the analysts forecasts that the company's dividends will grow at a fixed rate of 5% per year forever, then the constant growth model should be used. If, on the other hand, the analyst forecasts that the company's dividends will grow at a 15% growth rate for the next three years and then growth at a constant rate of 7% per year, then the differential growth model should be used. As you can see, there's a lot of estimation involved in applying the Dividend Discount Model. Because of this situation, it's useful to conduct a sensitivity analysis.

References:

Penman, S.H. (1997, November 5). A synthesis of equity valuation techniques and the terminal value calculation for the dividend discount model. Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=38720

Womack, K.L, & Zhang, Y. (2003, December 19). Understanding risk and return, the capm, and the fama-french three-factor model. Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=481881

Required:

Below are some questions for discussion.

1. Please apply the Dividend Discount Model to the common stock of a publicly-traded company of your choosing. Based off your results from the model, state whether you believe that the company's common stock is currently overvalued, overvalued, or fully valued. Please be sure to state your assumptions and justify your results.

2. Beta is one of the inputs into the CAPM. How's a stock's beta determined? Is beta a good measure of risk? Why or why not?

3. What are some competing models to the CAPM to determine a company's cost of equity? Compare and contrast them to the CAPM.

You must answer one of the above questions. You do not need to answer all three questions. You must also respond to at least two peers' posts over two separate days. Please try to add information not previously discussed by others. Please provide factual information (not merely opinions) backed up by details or examples. Your comments should be in your own words and include references in APA format.

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