Question

Provide the issues or disadvantages of a dividend discount model (Gordon Growth Model for equity and give a detailed quantitative example and interpretation. Use the following to calculate, D0=$2.20, g=5%, No debt, Beta 1.2, Rf = 3%, Rm = 10%. Solve for K (WACC) and Intrinsic Value to complete.

Answer 1

Issues or disadvantages of a dividend discount model
1. In real life dividends do not grow at constant rate and in some years dividends are not given. So it is very difficult to calculate
future expected dividends.
2. Growth rates are subjective and cannot be predicted with accuracy.
3.It does not include share buyback in its analysis.

Cost of equity using CAPM =Risk Free rate + Beta*(Market Return -Risk Free rate) =3%+1.2*(10%-3%) =11.40%
Intrinsic value of equity = D0*(1+g)/(Cost of equity - Growth) =2.20*(1+5%)/(11.40%-5%) =36.09