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# Dividend Discount Model

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Simtek currently pays a \$2.50 dividend (Do) per share. Next year's dividend is expected to be \$3 per share. After next year, dividends are expected to increase a a 9 percent annual rate for three years and a 6 percent annual rate thereafter.

a. What is the current value of a share of Simtek stock to an investor who requires a 25 percent return on his or her investment?
b. If the dividend is year 2 is expected to be \$3 and the growth rate over the following three years is expected to be only 7 percent and then 6 percent thereafter, what will the new stock price be?

The Seneca Maintenance Company currently (that is, as of year 0) pays a common stock dividend of \$1.50 per share. Dividends are expected to grow at a rate of 11 percent per year for the next four years and then to continue growing thereafter at a rate of 5 percent per year. What is the current value of a share of Seneca common stock to an investor who requires 24 percent rate of return?

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#### Solution Summary

The solution gives an example of stock valuation based on dividend discount model.

\$2.19
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## 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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