Question

1. Which of the following two firms should be applied the dividend discount model (DDM) to value its stock price? Explain.

• Firm XX with constant annual dividend payment since 10 years ago;
• Firm YY with constant dividend payout ratio (dividend payment/total earnings) since 10 years ago.

2. A preferred stock will pay a dividend of $2.75 in the upcoming year and every year thereafter. You require a return of 10% on this stock. Calculate the intrinsic value of this preferred stock.

Answer 1

Ans = 1) DDM should be apply to firm YY which have constant dividend payout ratio.

- Constant dividend payout ratio firm YY will pay the same ratio of dividend as per earnings per share for each year. This also help analyse to ascertain the long-term earning potential of firm, we can also determine the constant growth rate by finding out constant retention ratio. For eg firm dividend payout ratio is 10%, earning year 1=100 , year 2= 200, therefore firm will pay dividend in year 1 = 10, year 2 =20. Whereas retention ratio will 90% for both years.

- Whereas for the firm XX that pays constant dividend regardless of the earning should not use DDM model as it will not tell the long-term earnings potential for the firm. It will also give wrong retention ratio due to which we can't accurately determine the growth of future dividend . For eg firm pays $ 10 dividend for earning of $100 in year 1and same for year 2 earning of $200. Here retention ratio in year 1 is 90% where as in year 2 is 95% due to unstable retention ratio we cannot find the constant growth in dividend. Whereas DDM required a constant growth rate.

Ans 2) intrinsic value =27.5

- Intrinsic value of preferred stock = Dividend / require return.

- intrinsic value = 2.75 / 0.10 =27.5