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.

1. The dividend discount model can be modified to work with more complex patterns of dividend rates. When a two-stage model is used, the first stage is generally considered a _______________ while the second stage is generally considered a ______________.

a.   supernormal dividend rate; normal dividend rate

b.   just barely sustainable dividend rate; residual dividend rate

c.   normal dividend rate; supernormal dividend rate

d.   reasonable dividend rate; just barely sustainable dividend rate

1. Which statement below is correct regarding a multiple-stage dividend discount model?

a.   The two-stage dividend discount model is less sensitive to assumed growth rates than the single-dividend growth rate model.

b.   The three-stage dividend discount model is less sensitive to assumed growth rates than the two-stage dividend growth rate model.

c.   The Gordon Growth Model is better suited to a multiple-stage dividend discount model than a single-dividend growth rate model.

d.   To accurately determine a combination of growth rates that are just barely sustainable requires the analyst to estimate the value of the firm using some other method.

1. When a two-stage dividend discount model is used, the analyst must make assumptions about:

a.   the normal growth rate

b.   the supernormal growth rate

c.   the number of years of the firm’s supernormal growth rate

d.   All of the answers are correct.

1. Under the dividend discount model, the value of equity:

a.   will be zero when no dividends are paid by a firm

b.   is the present value of future dividends forever

c.   is the future value of the initial first-year dividends of a firm

d.   is easier to determine when no dividends are paid by a firm since g will equal the just barely sustainable dividend rate by default

1. In a two-stage dividend discount model, what is the relationship between the first and second stage growth rates?

a.   Generally, the first stage is the supernormal growth rate and the second is the normal growth rate, which is assumed to be sustainable indefinitely.

b.   Generally, the first stage is the normal growth rate and the second is the supernormal growth rate, which mirrors the firm’s growth and maturity as a competitor in the marketplace.

c.   The valuation formula requires that the stage one growth rate is always higher than the stage two growth rate.

d.   The valuation formula requires that the stage one growth rate is always lower than the stage two growth rate.

1. How is the just barely sustainable dividend stream used in a two- or three-stage dividend discount model?

a.   It is not necessary to use the just barely sustainable dividend stream in two-stage models.

b.   No matter how dividend streams are presented in the model, it is necessary to use a dividend stream that the firm’s net cash inflows can support, but just barely.

c.   In a two- or three-stage model, it is not necessary to use the just barely sustainable dividend stream for the stage considered to be the normal dividend growth rate.

d.   It is necessary to use the just barely sustainable dividend stream in a two-stage model, but its use is optional in a three-stage model.

1. In the flows to equity model:

a.   the just barely sustainable dividend growth rate is disregarded

b.   the dividend stream will not be the same as the flows to equity

c.   the dividend stream must match the flows to equity in each year

d.   the present value of the dividend stream must be equal to the present value of the net cash flows coming into the firm

1. In the flows to equity formula used to solve for common equity, cash flows to equity equal the free cash flows:

a.   from core operations plus nonoperating cash flows

b.   from core operations minus nonoperating cash flows minus debt service and flows to other capital providers

c.   plus nonoperating cash flow minus debt service and flows to other capital providers

d.   minus nonoperating cash flow plus debt service and flows to other capital providers

1. The valuation model that relies on the idea that the value of any security is the present value of the cash flows the security is expected to generate, which amount is identical to the cash flows into the firm’s equity component, is known as:

a.   dividend discount model

b.   free cash flow model

c.   flows to equity model

d.   None of the answers above are correct.

One key difference between the dividend discount and flows to equity models is:

a.   the flows to equity model looks at the cash flows that would be available to fund the dividend stream

b.   the dividend discount model looks at the cash flows that would be available to fund the dividend stream

c.   the flows to equity model looks at the dividend stream itself

d.   the dividend discount model discounts the free cash inflow into the equity component of the firm