Question

Mention in details the assumptions and limitations for the three models of dividend Growth Models:

1.    zero dividend growth

2.    constant dividend growth

3.    variable-growth

Answer 1

1]

The assumptions are :

• Dividends stays constant in perpetuity, i.e. there is no growth
• Required return stays constant in perpetuity
• value of stock = expected dividend per share / required return

The limitations are :

• The assumption of zero dividend growth is unrealistic
• Required return may change, but the model assumes no change in required return
• The value is highly sensitive to small changes in the inputs

2]

The assumptions are :

• Dividends growth rate stays constant in perpetuity
• Required return stays constant in perpetuity
• value of stock = expected dividend per share / (required return - constant growth rate)

The limitations are :

• The assumption of constant growth rate is unrealistic
• Required return may change, but the model assumes no change in required return
• Growth rate must be lower than the required return. Else, the value cannot be determined.
• The value is highly sensitive to small changes in the inputs

3]

The assumptions are :

• Dividends growth rate is high during the initial period, lower in the later period, before settling down to a constant growth rate
• value of stock = present value of dividends + present value of terminal value

The limitations are :

• Growth rate must be lower than the required return. Else, the value cannot be determined.
• The change growth rate is usually linear, and not abrupt. The model does not take this into consideration
• The value is highly sensitive to small changes in the inputs