Topic 7

EQUITY MARKETS AND STOCK

VALUATION
Answers to Concepts Review and Critical Thinking Questions

Q7.4 Dividend Growth Model. Under what two assumptions can we use the dividend
growth model presented in the chapter to determine the value of a share of stock?
Comment on the reasonableness of these assumptions.

The general method for valuing a share of stock is to find the present value of all
expected future dividends. The dividend growth model presented in the text is
only valid (i) if dividends are expected to occur forever; that is, the stock provides
dividends in perpetuity, and (ii) if a constant growth rate of dividends occurs
forever. A violation of the first assumption might be a company that is expected to
cease operations and dissolve itself some finite number of years from now. The
stock of such a company would be valued by the methods of this chapter by
applying the general method of valuation. A violation of the second assumption
might be a start-up firm that isn’t currently paying any dividends, but is expected
to eventually start making dividend payments some number of years from now.
This stock would also be valued by the general dividend valuation method of this
chapter.

Q7.6 Dividend Growth Model. Based on the dividend growth model, what are the
two components of the total return on a share of stock? Which do you think is
typically larger?

The two components are the dividend yield and the capital gains yield. For most
companies, the capital gains yield is larger. This is easy to see for companies that
pay no dividends. For companies that do pay dividends, the dividend yields are
rarely over five percent and are often much less.
 Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems
require multiple steps. Due to space and readability constraints, when these intermediate
steps are included in this solutions manual, rounding may appear to have occurred.
However, the final answer for each problem is found without rounding during any step in
the problem.

P0=? D0 (1 + g) D0 (1 + g)2 D0 (1 + g)3 D0 (1 + g)4

D0 = D1 = D2 = D3 = D4 ®¥

0 1 2 3 4

ß------------------------------------------------------- g -----------------------------------------------------------à¥

2
P0 = D1/(1+ R) + D2/(1+ R) + D3/(1+ R)
3
--- ¥

Therefore,

P0 = D1 / (R – g) or P0 = D0 (1 + g) / (R – g)

Q1. Stock Values. Umbak Properties just paid a dividend of $2.53 per share on its
stock. The dividends are expected to grow at a constant rate of 5.4 percent per
year, indefinitely. If investors require a 10 percent return on Umbak stock, what is
the current price? What will the price be in three years? In 15 years?
D0=2.53

P0=?

|_____________|___________|_____ॠR=10%
0 1 2
--------------------- g=5.4% ------------------------à¥
 The constant dividend growth model is:
Pt = Dt × (1 + g) / (R – g)xx or P0 = D1 / (R – g)
So, the price of the stock today is:
P0 = D1 / (R – g)
P0 = D0 (1 + g) / (R – g) xx
P0 = $2.53 (1.054) / (.10 – .054)
P0 = $57.97
Price of the stock in Yr 3
P0 = D1 / (R – g)
P3 = D4 / (R – g)
P3 = D3 (1 + g) / (R – g) xx
4
P3 = D0 (1 + g) / (R – g)
4
P3 = $2.53 (1.054) / (.10 – .054)
P3 = $67.88

Price of the stock in Yr 15

P0 = D1 / (R – g)
P15 = D16 / (R – g)
P15 = D15 (1 + g) / (R – g) xx
16
P15 = D0 (1 + g) / (R – g)
16
P15 = $2.53 (1.054) / (.10 – .054)
P15 = $127.59

There is another feature of the constant dividend growth model: The stock price
grows at the dividend growth rate. So, if we know the stock price today, we can
find the future value for any time in the future we want to calculate the stock price.
In this problem, we want to know the stock price in three years, and we have already
calculated the stock price today.
The stock price in three years will be:
3
P3 = P0(1 + g)
3
P3 = $57.97(1 + .054)
P3 = $67.88
 And the stock price in 15 years will be:
15
P15 = P0(1 + g)
15
P15 = $57.97(1 + .054)
P15 = $127.59

Q2. Stock Values. The next dividend payment by Lalitha Singhe Traders will be
$2.45 per share. The dividends are anticipated to maintain a 5.5 percent growth
rate, forever. If the stock currently sells for $49.50 per share, what is the required
return?

P0=49.50 D1=2.45

|_____________|___________|_____ॠR=?
0 1 2
--------------------- g=5.5% ------------------------à¥

We need to find the required return of the stock. Using the constant growth model,
we can solve the equation for R. Doing so, we find:
P0 = D1 / (R – g)
R = (D1 / P0) + g
R = ($2.45 / $49.50) + .055
R = .1045 or 10.45%

Q4. Stock Values. Ziggs Corporation will pay a $3.85 per share dividend next year.
The company pledges to increase its dividend by 4.5 percent per year, indefinitely.
If you require a 14 percent return on your investment, how much will you pay for
the company's stock today?

P0=? D1=3.85

|_____________|___________|_____ॠR=14%
0 1 2
--------------------- g=4.5% ------------------------à¥
 Using the constant growth model, we find the price of the stock today is:

P0 = D1 / (R – g)
P0 = $3.85 / (.14 – .045)
P0 = $40.53

Q6. Stock Valuation. Suppose you know that a company's stock currently sells for
$65 per share and the required return on the stock is 10 percent. You also know
that the total return on the stock is evenly divided between capital gains yield and
a dividend yield. If it's the company's policy to always maintain a constant growth
rate in its dividends, what is the current dividend per share?

Total return(yield) = Dividend yield + Capital gains yield i.e. R = (D / P ) +

1 0

g
We know the stock has a required return of 10 percent, and the dividend and
capital gains yield are equal, so:

Dividend yield = 1/2(.10)

Dividend yield = .050 = Capital gains yield

Or R = (D1 / P0) + g
10% = 5% + 5%

Now we know both the dividend yield and capital gains yield. The dividend is
simply the stock price times the dividend yield (since Dividend Yield =
Dividend/Stock Price), so:
0.05 = D1 / P0
D1 = .050($65)
D1 = $3.25

Or Dividend Yield = D1 / P0
D1 = Dividend Yield x P0
= 0.05 x 65
= $3.25
 This is the dividend next year. The question asks for the dividend this year. Using
the relationship between the dividend this year and the dividend next year:

D1 = D0(1 + g)

We can solve for the dividend that was just paid:

$3.25 = D0(1 + .05)

D0 = $3.25 / 1.05
D0 = $3.10

Q10. Growth Rates. The stock price of Jenkins Co. is $53. Investors require a 12
percent rate of return on similar stocks. If the company plans to pay a dividend of
$2.85 next year, what growth rate is expected for the company's stock price?

P0=53 D1=2.85

|_____________|___________|_____ॠR=12%
0 1 2
-------------------------- g=? ------------------------à¥

We need to find the growth rate of dividends. Using the constant growth model, we can
solve the equation for g. Doing so, we find:

P0 = D1 / (R – g)
g = R – (D1 / P0)
g = .12 – ($2.85 / $53)
g = .0662 or 6.62%

Q12. Stock Valuation. Olympis Sisters will pay a dividend of $2.60 next year. The
company has stated that it will maintain a constant growth rate of 4.5 percent a
year forever. If you want a 15 percent rate of return, how much will you pay for
the stock? What if you want a 10 percent rate of return? What does this tell you
about the relationship between the required return and the stock price?
 P0=? D1=2.60

|_____________|___________|_____ॠR=15%/10%
0 1 2
--------------------- g=4.5% ------------------------à¥

Here, we need to value a stock with two different required returns. Using the
constant growth model and a required return of 15 percent, the stock price today is:
P0 = D1 / (R – g)
P0 = $2.60 / (.15 – .045)
P0 = $24.76

And the stock price today with a 10 percent return will be:
P0 = D1 / (R – g)
P0 = $2.60 / (.10 – .045)
P0 = $47.27

All else held constant, a higher required return means that the stock will sell for a
lower price. Also, notice that the stock price is very sensitive to the required return.
In this case, the required return fell by 1/3 but the stock price almost doubled.

Extra Problem (Example)

1. BMW Ltd is about to be listed on the share market. You determine that BMW's
required return is 16.55%. Today’s dividend is $1.10 and after analysing their future
prospects you forecast their dividend in a year's time will be $1.20. You expect this
dividend to grow by 12% for the next two years after that and then settle down to a
constant growth of 3% pa thereafter. What is a fair price for a BMW share?
P0=?
D1=1.20 D2 D3 D4 ®¥
R=16.55%

0 1 2 3 4
¬------------------ g1=12% ------------- ¬----------------------- g2=3% ---------------
--------® --------à¥
D1=$1.20
D2=1.20(1.12)=$1.344
D3=1.2(1.12)2=$1.50528
D4=1.2(1.12)2(1.03) =$1.55044

P3= D4/(R – g2)

= 1.55044/(0.1655 – 0.03)
= $11.4423

Calculator: CF [2ND CLR WORK] CF0= 0 C01=1.2 F01=1 C02=1.344

F02=1 C03=(1.50528+11.4323) F03=1 NPV I=16.55 CPT NPV= 10.20

Formula: P0 = D1/(1 + R) + D2/(1 + R) 2 + (D3+ P3)/( 1 + R) 3

= 1.20/(1.1655) + 1.344/(1.1655) 2 + (1.50528+11.43)/(1.1655) 3
Extra Tute Question (Practice)
ABC Bhd’s dividends are expected to grow at a rate of 20% per year for the next two
years. At the end of the two years, ABC dividend growth is expected to grow at 5%
indefinitely. ABC has just paid a dividend of $1.10. Compute the current value of this
stock if the required rate of return is 15%.

D0=1.10

P0=? D1 D2 D3…¥

|_____________|___________|___________|_______ॠR=15%

0 1 2 3
<--------- g1=20% -------------àß----- g2=5%---------à¥
D1 = 1.10 (1.20) = $1.32
D2 = 1.32(1.20) = $1.584
D3 = 1.584(1.05) = $1.6632

P2 =D3/r-g2
= $1.6632/(0.15 - 0.05)
 = $16.632

CF [2ND CLR WORK] CF0= 0 C01=1.32 F01=1 C02=(1.584 +16.632)

F02=1 NPV I=15 CPT NPV= 14.92
Actual:
CF [2ND CLR WORK] CF0= 0 ↓ C01=1.32 Enter ↓↓ C02= (1.584
+16.632=) Enter NPV I=15 Enter ↓ CPT NPV= 14.92