Question

Describe the events that occur in an efficient market in response to new information that causes the expected return to exceed the required return. What happens to the market value?

Describe, compare, and contrast the following common stock dividend valuation models: (a) zero-growth, (b) constant-growth, and (c) variable-growth.

Answer 1

A. The market adjustment to new information can be viewed interms of rates of return. At each point in time, investors estimate the expected return. When the expected return exceeds the required return, investors start buying the asset driving up its market price to the point where the expected and required returns are equal.

B. Zero Growth Model: It assumes a constant, non-growing dividend to investors for the lifetime of the asset. The stock valuation till perpetuity gives the intrinstic value of the asset as
P₀ = D/k_s, where k_s is the required return/cost of equity

Constant Growth Model: It assumes dividends grow at a constant rate throughout lifetime of the asset. The stock valuation till perpetuity gives the intrinstic value of the asset as
P₀ = D₀ x (1 + g) /(k_s - g),
where, k_s is the required return/cost of equity, g is dividend growth rate, D₀ is the dividend at time 0.

Variable Growth Model: It assumes that dividends grow at a variable rate.The stock with a single shift in the growth rate is valued as the present value of the dividend stream during the initial growth phase plus the present value of the price of stock at the end ofthe initial growth phase.