ch8

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• The dividend discount model is based on the idea that the value of any security is the present value of the security’s expected future cash flows as discounted at a rate of return demanded by the holders of that security. Therefore, the value of common equity in the dividend discount model is equal to the present value of the:

• a.   expected common dividend stream during the holding period

  b.   expected common dividend stream during the holding period plus the present value of the future stock price

  c.   expected common dividend stream during the holding period plus the future value of the current stock price

  d.   discounted cost of equity for the security

1. Which statement below is incorrect regarding the dividend discount model?

a.   Forecasting the dividend stream correctly in the model is complicated.

b.   The value of the equity is the present value of all the expected future returns.

c.   The value of the firm’s equity is dependent on the investor’s investment horizon.

d.   The holder of a share of stock will receive dividends over the holding period, plus the value of the stock when he or she sells it.

1. The dividend discount model requires a forecast for an infinite number of years. Since this assumption is not reasonable or practical to calculate, the Gordon Growth Model is used, which assumes that:

a.   the initial dividend used in the formula is the expected dividend in the first year of the future dividend stream

b.   a reasonable cost of equity can be determined using an asset pricing model such as CAPM

c.   the dividend growth rate for the firm is the rate just barely sustainable over the long run for which the firm would have sufficient resources to pay a specified dividend but would not build up any excess cash

d.         All of the answers above are correct

1. One of the assumptions used in the Gordon Growth Model is that of the dividend growth rate. What is the relationship between g and g* in this model?

a.   g represents a constant rate of growth whereas g* represents a constant rate of growth for time period

       *.

b.   g represents the initial expected dividend for the first year whereas g* represents the growth in the dividend rate over a multiple-year reporting period.

c.   g represents a constant rate of growth whereas g* represents the just barely sustainable growth rate.

d.   There is no relationship between g and g* since g will never be equal to g*.

1. When using the dividend discount model, the firm is properly valued only when g = g*, where g* is the just barely sustainable growth rate. To be accurate and correct using the dividend discount model, the analyst must:

a.   value the firm without analyzing the just barely sustainable dividend growth rate

b.   value the firm using some other method before using the dividend discount model

c.   pick a dividend growth rate that approximates growth in the economy

d.   solve for g first, then solve for g*, making the dividend discount model of value to the analyst

1. An analyst working with the dividend discount model uses a growth rate that is greater than g*. The result of using this particular growth rate is that the firm would:

1. eventually have to borrow money to make its dividend payments
2. build up an infinite amount of cash, which would never be paid out in dividends
3. never have to borrow money to pay dividends to equityholders
4. be able to use excess accumulated cash for investment purposes, thus increasing the value of its equity

1. For an analyst to use the dividend discount model as a reliable method of valuation, the estimates of g must be very close to g*. In this situation g* represents:

1. the dividend growth rate that approximates the growth in the economy over the long run
2. the dividend growth rate that makes excess cash tend toward zero over the long run for the firm
3. a variable that is greater than g over the long run for the firm
4. a variable that is less than g over the long run for the firm

1. To accurately estimate g*, an analyst is likely to use an approach such as:

a.   the historical dividend growth rate for the firm

b.   the expected growth rate in the economy or industry

c.   the expected inflation over the long run for the firm

d.   None of the above choices are correct.