Question

QUESTION 2.
Remember that just like projects, bonds, or any other asset, the intrinsic value (fair value of
any asset) is just the present value of all of its future cash flows. For stocks, these future cash
flows are dividends. Even if a firm does not currently pay any dividends, it is fair to assume
that it will in the future. Even if the investor does not plan on holding on to a stock for a very
long time, whomever the shares will be sold to after a period of time will have to value them
and will use future dividends in his/her valuation, etc, etc.
Calculate the fair value (intrinsic value) of ABC’s common shares today if last dividend paid
(Do) was equal to $2 per share, beta is 1.4, expected market return is 9%, risk-free rate is 3%
and dividends are expected to grow at a rate equal to 5% per year, indefinitely. (g=5%) This
means that D1=Do(1+g), D2=D1(1+g)=Do(1+g)(1+g)=Do(1+g)^2, Dn=Do(1+g)^n, etc
In this case, we can use the (Gordon’s) Constant Growth Model to find the fair value
(intrinsic value) of ABC Inc.’s shares today. The Constant Growth Model says that the fair
value today, Po, can be found like this: Po = D1 / (Rs – g) = Do(1+g) / (Rs-g) , where D1 is the
next (future) dividend, Rs is the required return on equity and g is the constant growth rate.
Please note that if g=0%, meaning that the dividends are expected to remain constant, the
formula above simply reduces to Po= D1 / (Rs-g)=D1(Rs-0%)=D1/Rs = Do(1+g) / Rs, which if
you remember is the formula for present value of a perpetuity.
HINT: USE CAPM MODEL TO FIND Rs

Answer 1

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