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• Multi-period Model:
• The above special case is sometimes called a perpetual growth model and is
also useful in evaluating preferred stock.
LIMITATIONS OF CONSTANT GROWTH DDM:
1. Restricted to firms that are growing at a stable growth rate;
2. Should not be used to those companies which have high current growth rates;
3. Ke > g and initial dividend (D0)must be greater than zero.
• THE DIVIDEND DISCOUNT MODEL: Cont…
• Multistage growth models: Two-Stage DDM
-- Whenever the growth rate is not constant we cannot use the div.discount model.
-- In reality, through the different stages of the firms’ life cycles they have different
dividend profiles.
• In early stages, payout ratios are low; more inv. Opportunities and rapid growth.
• In later stages, payout ratios are high; production capacity is enough to meet the
demand; less investment opportunities; stable growth.
Growth Rate
Payout Ratio
Problem on Three-stage DDM:
V Ltd. has EPS of Rs.2 last year,
Div. Pay-out = Re.1
Current growth rate = 18% will be maintained for next 4 yrs,
Length of transition period = 4 yrs,
Stable growth rate 6%,
Current Rf = 8%; β = 1.2; Rm = 13%, i.e. current required rate of return = 14%,
After the growth rate stabilizes : Rf = 7%; β = 1.0; Rm = 10%, i.e. required rate of return
after 4 yrs will be = 10%.
Div. Pay-out ratio after 4 years = 0.70
Calculate the intrinsic value of the company and comment thereon if the current market
price of the share is Rs.9.50
WHICH GROWTH PATTERN SHOULD BE USED?
If your firm is: • large and growing at a rate close to or less than growth rate
of the economy, or • constrained by regulation from growing at rate faster than
the economy;
• has the characteristics of a stable firm (average risk & reinvestment rates)
n
P0 = Σ FCFE0 (1+gs)t + FCFEn (1+gn)
t=1 (1+ke)t (ke- gn) (1+ke)n
Problem based on FCFE: Data relating to a Communication company is as follows:
Current EPS = Rs.4.00; Capex per share = Rs.3.70; Dep = Rs.1.70 per sh.
Increase in WC = Rs. 1.00; Debt ratio = 20%; Rf = 7%; β = 1.3; Rm = 10%
Supernormal growth rate is 22% for the next 5 ys. and thereafter at 10%.
Calculate intrinsic value per share.
Sol: Required rate of return is = 7% + 1.3(10-7) = 10.9%
Year 1 2 3 4 5
EPS 4.88 5.95 7.26 8.86 10.8
Less: (1-δ) (Capital expenditure
– Depreciation) 1.95 2.38 2.91 3.55 4.33
Less: (1- δ) (Increase in
working capital) 0.80 0.98 1.19 1.45 1.77
FCFE 2.13 2.59 3.16 3.86 4.71