Notations

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Chapter 7 – Formulas

𝐷𝑖𝑣 1 + 𝑃 1 𝐷𝑖𝑣1 + 𝑃 1 𝐷𝑖𝑣1 𝑃1 − 𝑃 0

𝑃0= 𝑟 𝐸= −1= +
1+𝑟 𝐸 𝑃0 𝑃0 𝑃0

𝐷𝑖𝑣1 𝐷𝑖𝑣 0 ×(1+ 𝑔) 𝐷𝑖𝑣1

𝑃0= = 𝑟 𝐸= +𝑔
𝑟𝐸−𝑔 𝑟𝐸−𝑔 𝑃0

𝐷𝑖 𝑣1 𝐷𝑖 𝑣 2 𝐷𝑖 𝑣 𝑁 𝑃𝑁 𝐷𝑖𝑣 𝑁 +1
𝑃0= + + …+ + 𝑃 𝑁=
1+𝑟 𝐸 ( 1+𝑟 𝐸 )2
( 1+𝑟 𝐸 )
𝑁
( 1+𝑟 𝐸 )
𝑁
𝑟𝐸−𝑔

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Example 7.1 Stock Prices and
Returns (1 of 3)
Problem
• Suppose you expect Longs Drug Stores to pay an annual
dividend of $0.56 per share in the coming year and to
trade for $45.50 per share at the end of the year.
Investments with equivalent risk to Longs’ stock have an
expected return of 6.80%.
– What is the most you would pay today for Longs’
stock?
– What dividend yield and capital gain rate would you
expect at this price?

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Example 7.1 Stock Prices and
Returns (2 of 3)
Solution
(Div1  $0.56) (P1  $45.50) (rE  0.068).

Price: 𝐷𝑖𝑣 1 + 𝑃 1 0 .56+ 4 5.50

𝑃0= = =$ 43.13
1+𝑟 𝐸 1.068

Dividend yield: 𝐷𝑖𝑣1 0.56

= =1.3 %
𝑃0 43.13

Capital gains yield: 𝑃 1 − 𝑃 0 45.50 − 43.13

= =5.5 %
𝑃0 43.13

Total return: 𝑟 𝐸 =1.3 % +5.5 %=6.8 %

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Example 7.1 Stock Prices and
Returns (3 of 3)
Evaluate
• At $43.13, the investor’s expected total return is 6.8%
which is equal to the cost of capital.
• This is the most we would be willing to pay for Longs’
stock.
• If we paid more, our expected return would be less than
6.8%, and we would rather invest elsewhere.

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Example 7.2 Valuing a Firm with
Constant Dividend Growth (1 of 2)
Problem
• Consolidated Edison, Inc. (Con Ed) is a regulated utility
company that services the New York City area. Suppose
Con Ed plans to pay $2.30 per share in dividends in the
coming year. If its equity cost of capital is 7% and
dividends are expected to grow by 2% per year in the
future, estimate the value of Con Ed’s stock.

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Example 7.2 Valuing a Firm with
Constant Dividend Growth (2 of 2)
Solution

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

 7.4 Estimating Dividends in the
Dividend-Discount Model (3 of 12)

• How can managers maximize the stock price ()?

– Increase current dividends () 𝐷𝑖𝑣1
– Increase the expected growth rate ( 𝑃0=
𝑟𝐸−𝑔
– Reduce the cost of capital ()

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Example 7.5a Valuing a Firm with
Nonconstant Growth Rates (1 of 2)
Problem
• Consider the case of a company is currently not paying
dividends. You predict that, in 5 years, the company will
pay a dividend for the first time. The dividend will be
$.50 per share. You expect this dividend to grow at 10%
per year indefinitely. The required return on companies
such as this one is 20%. What is the price of the stock
today?

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Example 7.5a Valuing a Firm with
Nonconstant Growth Rates (2 of 2)
Solution
• Find out what it will be worth once dividends are paid; the
price in four years will be:

• If the stock is worth $5 in four years, then we can get the

current value by discounting this price back four years at
20%:

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

The Dividend-Discount Model
Table 7.1: The Dividend-Discount Model
𝐷𝑖 𝑣1 𝐷𝑖 𝑣 2
A formula: P naught = div sub 1 divided by 1 + r sub E, + div sub 2 divided by, 1 + r sub E, squared, and so on, plus div sub N divided by, 1 + r sub R, raised to the N power, + P sub n divided by, 1 + r sub E, raised to the N power.

General formula
𝑃0= +
1 +𝑟 𝐸 ¿¿

𝐷𝑖𝑣 1
P subscript 0 equals start fraction Div subscript 1 over r subscript E minus g end fraction.

If dividend growth is
constant 𝑃0=
𝑟𝐸−𝑔

𝐷𝑖 𝑣1 𝐷𝑖 𝑣 2
P sub 0 = start fraction Div sub 1 over 1 + r sub E end fraction + start fraction Div sub 2 over left parenthesis 1 + r sub E right parenthesis to the second power end fraction + ellipsis + start fraction Div sub N over left parenthesis 1 + r sub E right parenthesis to the power of N end fraction + left parenthesis 1 over left parenthesis 1 + r sub E right parenthesis to the power of N right parenthesis left parenthesis Div sub N minus 1 over r sub E minus g right parenthesis.

If early growth is
variable followed by 𝑃0= +
1 +𝑟 𝐸 ¿¿
constant growth

Copyright © 2021 Pearson Education, Inc. All Rights Reserved

Chapter Quiz
1. What are some key differences between preferred and
common stock?
2. What discount rate do you use to discount the future cash
flows of a stock?
3. What are three ways that a firm can increase the amount
of its future dividend per share?
4. What are the main limitations of the dividend-discount
model?
5. How does the total payout model address part of the
dividend-discount model’s limitations?

Copyright © 2021 Pearson Education, Inc. All Rights Reserved