CHAPTER 8 STOCK VALUATIONAnswers to Concepts Review and Critical Thinking Questions 1.The value of any investment depends on the present value of its cash flows; i.e., what investors will actually receive. The cash flows from a share of stock are the dividends. 2.Investors believe the company will eventually start paying dividends (or be sold to another company). 3.In general, companies that need the cash will often forgo dividends since dividends are a cash expense. Young, growing companies with profitable investment opportunities are one example; another example is a company in financial distress. This question is examined in depth in a later chapter. 4.The general method for valuing a share of stock is to find the present value of all expected future dividends. The dividend growth model presented in the text is only valid (i) if dividends are expected to occur forever, that is, the stock provides dividends in perpetuity, and (ii) if a constant growth rate of dividends occurs forever. A violation of the first assumption might be a company that is expected to cease operations and dissolve itself some finite number of years from now. The stock of such a company would be valued by applying the general method of valuation explained in this chapter. A violation of the second assumption might be a start-up firm that isn’t currently paying any dividends, but is expected to eventually start making dividend payments some number of years from now. This stock would also be valued by the general dividend valuation method explained in this chapter. 6.The two components are the dividend yield and the capital gains yield. For most companies, the capital gains yield is larger. This is easy to see for companies that pay no dividends. For companies that do pay dividends, the dividend yields are rarely over five percent and are often much less. 7.Yes. If the dividend grows at a steady rate, so does the stock price. In other words, the dividend growth rate and the capital gains yield are the same. 12.If this assumption is violated, the two-stage dividend growth model is not valid. In other words, the price calculated will not be correct. Depending on the stock, it may be more reasonable to assume that the dividends fall from the high growth rate to the low perpetual growth rate over a period of years, rather than in one year.
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