SD8-THE DIVIDEND DISCOUNT AND FlOWS TO EQUITY MODELS

SD8-THE DIVIDEND DISCOUNT AND FlOWS TO EQUITY MODELS -...

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CHAPTER 8 THE DIVIDEND DISCOUNT AND FLOWS TO EQUITY MODELS LEARNING OBJECTIVES 1. The dividend discount model. 2. The assumptions of the dividend discount model. 3. The concept of a just barely sustainable dividend stream and its importance to the dividend discount model. 4. The limitations of the dividend discount model. 5. How the flows to equity model works. 6. Why the flows to equity and dividend discount models are equivalent. TRUE/FALSE QUESTIONS 1. There are two items of cash flows equityholders expect to receive from a stock investment. (moderate, L.O. 1, Section 1, true) 2. The dividend discount model discounts only dividends and as such does not consider net cash flows into the firm. (moderate, L.O. 2, Section 2, false) 3. The reasonableness of the dividend discount model lies in its ability to measure the present value of discounted cash flows from dividends, not from the assumptions used in the model itself. (moderate, L.O. 2, Section 2, false) 4. A small spread between the cost of equity and the growth rate causes the sensitivity to vary in the dividend growth rate. (difficult, L.O. 2, Section 2, true) 5. A modest error in the value of g will cause a modest valuation error. (moderate, L.O. 2, Section 2, false) 6. To properly value a firm using the dividend discount model, we must value the firm using some other method first. (moderate, L.O. 3, Section 2, true) 7. Selecting a “reasonable” dividend growth rate when using the dividend discount model is sufficient for most analyses. (difficult, L.O. 4, Section 2, false) 8. When working with a multiple-stream dividend discount model, it is important to remember that the just barely sustainable divided rate is not as critical as it is with a single-stream dividend discount model. (moderate, L.O. 4, Section 3, false) 9. The two-stage dividend discount model is very sensitive to assumed dividend growth rates. (moderate, L.O. 4, Section 4, true) 10. Although the dividend discount model is not practical to apply, it is still important to understand how it functions since it is the basis for other cash flow models. (moderate, L.O. 4, Section 4, true) 11. Using the long-term inflation rate assumption may appear to be a reasonable estimate in a dividend discount valuation model, but there is no way to test if such an assumption is the just barely sustainable 49
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rate for the firm. (moderate, L.O. 4, Section 4, true) 12. The higher the supernormal growth rate, the higher the normal growth rate. (moderate, L.O. 4, Section 4, false) 13. When a firm does not pay dividends, investors make an assumption that there will be a payout at some time in the future when a firm is sold or liquidated. (moderate, L.O. 4, Section 5, true) 14. In the flows to equity model, the assumption is made that the present value of the dividend stream is discounted at the rate of return demanded by the holders of the security.
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