Question

A relatively new firm has the dividend payment history. Suppose this stock sells for $8 per share. Estimate the shareholders' required rate of return using the dividend discount model with the following:

A. The dividend growth rate calculated over the firm's entire history.

B. The growth rate calculated over the actual dividend paying history only.

C. Why are the two answers different? Which do you think is most meaningful?

Table 9-10

Year dividends

2000 0

2001 0

2002 0

2003 0

2004 .10

2005 .13

2006 .15

2007 .18

Answer 1

The dividend growth rate = (Last dividend - First dividend)/first dividend * 100 = (0.18-0.10)/0.10 = *100 = 80%

(a) If growth rate iscalculated over the firm's entire history, the number of years = 8, so annual growth rate of dividends = 80%/10 = 10% annually

g =10% =0.1, Current dividend(D0) = 0.18, price (P0) = 8

As per dividend discount model, r = D0*(1+g)/P0 + g

r = 0.18*(1+0.1)/8 + 0.10 = 0.12475

Required rate of return = 12.475%

(b) When we consider only dividend paying history, the number of years = 4

Dividend growth rate = 80%/4 = 20%

g =20% =0.2, D0 =0.18, P= 8

As per dividend discount model, r = D0*(1+g)/P0 + g

r = 0.18*(1+0.2)/8 + 0.2 = 0.227 = 22.70%

Required rate of return = 22.70%

(c) The two rates are different becuase the dividend growth rate differes in the two cases since the number of years in consideration vary. The more meaningful one is to consider only the actual dividend paying hsitory