Question

Discuss the assumptions of the dividend discount model (DDM) and the information needed to conduct equity valuation using the DDM. Give one alternative method of valuation from your text that can be used if all of the necessary information needed for the DDM valuation is not available.

Answer 1

Q. 1). Answer :- The assumptions of dividend discount model (DDM) are as follows :-

a). The firm only uses retained earnings for financing its investment. It is all-equity firm.

b). In the firm, cost of capital (k) remain unchanged.

c).The firm has perpetual life.

d). There are no corporate taxes.

e). The retention ratio is constant after once the firm decided it.

The formula for computing value of share using dividend discount model (DDM) is as follows :-

Value of equity share = Expected dividend per share / (Cost of capital - Growth rate in dividend).

Accordingly, The following information is needed for calculating value of equity share using dividend discount model (DDM) :-

i). Current dividend per share.

ii). Growth rate in dividend

iii). Cost of capital.

By adding growth rate to current dividend, Expected dividend per share is arrived. (Expected dividend = Current dividend per share + Growth rate in dividend)

Q. 2). Answer :- Other alternative methods of valuing equity share are as follows :-

i). Walter model of dividend policy.

ii). Modigliani-Miller (MM) Theory.