Dividend Discount Model

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Financial Market Revision
Question 1 Performance Evaluation Calculation Discursive 20% 80% Question 2 Dividend Valuation Model 45% 55% Question 3 Option strategies Straddles 80% 20% Question 4 Duration and convexity –Price – yield relationship 30% 70% Question 5 Option and Futures -mixed N/A 100% Question 6 CAPM 40% 60%

Dividend Discount Models 1. The intrinsic value, denoted V0, of a share of stock is defined as the present value of all cash payments to the investor in the stock, including dividends as well as the proceeds from the ultimate sale of the stock, discounted at the appropriate risk-adjusted interest rate, k. Whenever the intrinsic value, or the investor’s own estimate of what the stock is really worth, exceeds the market price, the stock is considered undervalued and a good investment. 2. Dividend Discount Model: Stock valuation model that solves for the value of a common stock as the present value of future dividends expected to be received. 3. The dividend discount model holds that the price of a share of stock should equal the present value of all future dividends per share, discounted at an interest rate commensurate with the risk of the stock. 4. The constant growth dividend discount model is best suited for firms that are expected to exhibit stable growth rates over the foreseeable future. In reality, however, firms progress through lifecycles. In early years, attractive investment opportunities are ample and the firm responds with high plowback ratios and rapid dividend growth. Eventually, however, growth rates level off to more sustainable values. Threestage growth models are well-suited to such a pattern. These models allow for an initial period of rapid growth, a final period of steady dividend growth, and a middle, or transition, period in which the dividend growth rate declines from its initial high rate to the lower sustainable rate. 5. Problems of dividend-based valuations:  investors tend to have very different expectations from each other (Modigliani and Miller’s theories can hardly cope with the present-day wide difference in attitude between institutional and individual investors);  most investors look for a return based on two components: dividend and capital appreciation leading to capital gain on sale of the shares;  The mechanistic aspect of all such models. It should be noted that d0 is, of course, much dependent on EPS, and the factors mentioned above in regard to earnings-based valuations must be taken into account.  Dividend-based valuations are suitable for valuing small shareholdings rather than for valuing a controlling interest.

Past paper questions: Question 1: a) Discuss how you would value the share price of a newly formed internet company which will grow at a non constant rate for the first n years and then grow at a constant rate g forever. b) A company forecasts that its dividends for the next five years will be £ £ £ £ and £ After that, 1, 2, 3, 4 5. growth will decline to a steady 5% annually. If the company’s share price is currently trading at £55, what is the rate of return obtained by buying the company stock? c) Explain the limitations of the approach you have used to calculate the stock return.

Question 2: a) Explain, how you would value the stock of a newly started technology company which is expected to grow at non constant rate for the first n years of its existence and thereafter expected to grow at a constant rate forever. b) Assume the technology company pays a constant dividend of £ per share during the first five years, 2 during the next five years it pays dividends of £ £ £ £ and £ respectively. Thereafter the company 3, 4, 5, 6 7 has a steady growth of 7% per year till perpetuity. Assuming the expected return from the stock is 13%, what is the value of the stock? c) Under, what circumstances would the approach in part b) be invalid? Question 3: At year end 2001, the consensus among City analysts was that Innovation plc’s earnings and dividends...
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