# Dividend Discount Model

1. The Club Auto Parts Company has just recently been organized. It is expected to experience no growth for the next 2 years as it identifies its market and acquires its inventory. However, Club will grow at an annual rate of 5% in the third year and, beginning with the fourth year, should attain a 10% growth rate that it will sustain thereafter. The first divident to be paid at the end of the first year is expected to be $0.50 per share. Investors require a 15% rate of return on Club's stock. What is the current equilibrium stock price?

2. Johnson Corporation's stock is currently selling at $45.83 per share. The last dividend paid was $2.50. Johnson is a constant growth firm. If investors require a return of 16% on Johnson's stock, what do they think Johnson's growth rate will be?

3. Assume that the average firm in your company's industry is expected to grow at a constant rate of 7% and its dividend yield is 8%. Your company is about as risky as the average firm in the industry, but it has just successfully completed some R&D work that leads you to expect you to expect that its earnings and dividends will grow at a rate of 40% this year and 20% the following year, after which growth should match the 7% industry average rate. The last dividend paid was $1. What is the current value per share of your firm's stock?

4. Hanebury Manufacturing Company has preferred stock outstanding with a par value of $50. The stock pays a quarterly dividend of $1.25 and has a current price of $71.43. What is the nominal rate of return on the preferred stock?

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#### Solution Preview

1. The Club Auto Parts Company has just recently been organized. It is expected to experience no growth for the next 2 years as it identifies its market and acquires its inventory. However, Club will grow at an annual rate of 5% in the third year and, beginning with the fourth year, should attain a 10% growth rate that it will sustain thereafter. The first divident to be paid at the end of the first year is expected to be $0.50 per share. Investors require a 15% rate of return on Club's stock. What is the current equilibrium stock price?

We have to use the dividend discount model to arrive at the price. Since there are three period of growth, the dividends will be as per the details below :

Year 1 Year 2 Year 3 Year 4 Year 5

Dividend 0.50 0.50 0.525 0.5775 0.63525

Growth Rate 0 ...

#### Solution Summary

The solution explains calculation of stock price, growth rate using the dividend discount model. It also has calculation for return on a preferred stock

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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