rgonzalez

Analyst Kelvin Strong is arguing with fellow analyst Martha Hatchett. Strong insists that the dividend discount model can be used to calculate the required return for a stock, though only if the growth rate remains constant. Hatchett maintains that while such models are useful for calculating the value of a stock, they should not be used to calculate required returns. Who is CORRECT?

Strong

Hatchett

A) Correct Incorrect

B) Incorrect Incorrect

C) Incorrect Correct

---

Dividend discount models can be used to calculate required returns, assuming you have the stock price, dividends, and dividend-growth rates, so Hatchett is wrong. Strong is right about the fact that a DDM can calculate required returns, but wrong about the growth rate assumption. Multistage dividend discount models can account for expected changes in the growth rate.

rgonzalez

In using the capital asset pricing model (CAPM) to determine the appropriate discount rate for discounted cash flow models (DCFs), the asset’s beta is used to determine the amount of:

A) the expected return in addition to the return required by the risk of the position.

B) risk-free rate applicable to the time period of the investment.

C) equity premium.

---

Beta measures the correlation between the equity market or index for which the market risk premium is calculated and the particular asset being valued. Beta is used to approximate the proportion of the equity risk premium applicable to the asset (in relation to the market or index used).

rgonzalez

If the risk-free rate is 6%, the equity premium of the chosen index is 4%, and the asset’s beta is 0.8, what is the discount rate to be used in applying the dividend discount model?

A) 9.20%.

B) 7.80%.

C) 10.80%.

---

The discount rate = risk-free rate + beta (return expected on equity market less the risk-free rate). Here, discount rate = 0.06 + (0.8 × 0.04) = 0.092, or 9.2%.

rgonzalez

Which of the following is least likely a valid approach to determining the appropriate discount rate for a firm’s dividends?

A) Capital asset pricing model (CAPM).

B) Arbitrage pricing theory (APT).

C) Free cash flow to firm (FCFF).

---

FCFF is another discounted cash flow model, not a method to determine required returns. Each of the other answers is a valid approach to determining an appropriate discount rate.

rgonzalez

If we know the forecast growth rates for a firm’s dividends and the current dividends and current value, we can determine the:

A) net margin of the firm.

B) required rate of return.

C) sustainable growth rate.

---

Just as we can determine the current value of the shares from the current dividends, growth forecasts and required return, we can solve for any one of them if we know the other three factors

rgonzalez

An investor buys shares of a firm at $10.00. A year later she receives a dividend of $0.96 and sells the shares at $9.00. What is her holding period return on this investment?

A) -0.8%.

B) -0.4%.

C) +1.2%.

---

The holding period return = ($0.96 + $9.00 / $10.00) – 1 = –0.004 or –0.4%

rgonzalez

Given that a firm’s current dividend is $2.00, the forecasted growth is 7%, declining over three years to a stable 5% thereafter, and the current value of the firm’s shares is $45, what is the required rate of return?

A) 7.8%.

B) 9.8%.

C) 10.5%.

---

The required rate of return is 9.8%.
r = ($2/$45) [(1 + 0.05) + (3/2)(0.07 – 0.05)] + 0.05 = 0.0980Since the H-model is an approximation model, it is possible to solve for r directly without iteration

rgonzalez

Given that a firm’s current dividend is $2.00, the forecasted growth is 7% for the next two years and 5% thereafter, and the current value of the firm’s shares is $54.50, what is the required rate of return?

A) 9%.

B) Can’t be determined.

C) 10%.

---

The equation to determine the required rate of return is solved through iteration.
$54.50 = $2(1.07) / (1 + r) + $2(1.07)2 / (1 + r)2 + {[$2(1.07)2(1.05)] / (r - 0.05)} / [(1 + r)2
Through iteration, r = 9%

rgonzalez

CAB Inc. just paid a current dividend of $3.00, the forecasted growth is 9%, declining over four years to a stable 6% thereafter, and the current value of the firm’s shares is $50, what is the required rate of return?

A) 9.8%.

B) 10.5%.

C) 12.7%.

---

The required rate of return is 12.7%.
r = ($3 / $50)[(1 + 0.06) + (4 / 2)(0.09 − 0.06)] + 0.06 = 12.7%
Since the H-model is an approximation model, it is possible to solve for r directly without iteration

rgonzalez

Recent surveys of analysts report long-term earnings growth estimates as 5.5% and a forecasted dividend yield of 2.0% on the market index. At the time of the survey, the 20-year U.S. government bond yielded 4.8%. According to the Gordon growth model, what is the equity risk premium?

A) 7.5%.

B) 0.4%.

C) 2.7%.

---

Equity risk premium = 2.0% + 5.5% – 4.8% = 2.7%