Question

The DDM predicts that the intrinsic value of common shares will increase as a result of all of the following except

a. A decrease in the discount rate

b. an increase in the ROE

c. an increase in the plowback ratio

Please explain why, thanks.

d. an increase in the dividend payout ratio.

Answer 1

Option D will be the answer. The intrinsic value is given by the formula:

Price = Div/(r-g) where r is the cost of capital and g is the growth rate. The formula for growth is given as: g= b x RoE where RoE is the return on equity and b is the plowback ratio. The plowback ratio is also given as = 1 - dividend payout ratio. Hence, we see that with a decrease in r, the intrinsic value will increase and with an increase in g also, it will increase. Hence, options a,b and c point towards increasing price but option d points towards decreasing intrinsic value.