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The Gordon growth model is most likely to produce useful results when the dividend growth
rate is:
A) negative.
B) greater than the required rate of return.
C) equal to the required rate of return.
A team of analysts at WSM investments are currently analyzing the equity value of Shotput
Inc., which they believe may be a potential takeover target for some of its rivals. Three of the
analysts, Jeff Capes, CFA, Sven Karlson, CFA, and Zydrunas Savickas, CFA, are using the
dividend discount model to try to value the company.
Jeff Capes, CFA, decided to use the constant growth Dividend Discount Model (DDM) to
estimate the equity value. He is using the following information from Shotput's financial
statements for the year just ended:
Income Statement
$m
Revenues
850
COGS
580
SG&A
200
Depreciation expense
50
Earnings before tax
20
Taxes
10
Net income
10
Dividend
6
Balance Sheet
$m
Cash
10
Accounts receivable
450
Prepaid expenses
50
Fixed assets
400
Total assets
910
Current liabilities
550
Long-term debt
156
Equity
204
Total liabilities & equity 910
In order to calculate Return on Equity, Jeff calculates and uses the opening equity figure of
$200m.
Capes has identified a company in the same industry, Discus Inc., which has the same size
and risk characteristics as Shotput. He has decided to use the following information on
Discus to estimate a required return for equity holders of Shotput:
Equity market value
$62.94m
Dividend just paid
$5.5m
Sustainable growth rate 3%
Capes is also interested in calculating the present value of growth opportunities (PVGO) for
Shotput. He is proposing to use the last dividend paid by Shotput and divide it by the
required rate of return to get the value of its assets in place, and compare this to the
fundamental value to get PVGO.
Sven Karlson, CFA, is also estimating an equity value for Shotput using the DDM. He has
estimated a required return for equity of 11% using the Capital Asset Pricing Model. He has
also picked up the dividends just paid as $6m from the financial statements.
Karlson, however, is uncertain about how dividends will grow and feels that Shotput has a
competitive advantage over its rivals in the short term, which will lead to increased dividend
growth for the next few years. He has therefore assumed that for the first three years the
dividend growth rate will be 7% p.a., and then will decline linearly over the next six years to
2% p.a., a growth rate that will then be sustained for the foreseeable future.
Zydrunas Savickas, however, has questioned the use of the DDM for the purposes of their
research. They are hoping to present their findings to one of Shotput's competitors who they
feel may be in a position to launch a takeover bid and realize a gain from Shotput's current
undervaluation.
Savickas states, "While I accept that a benefit of the dividend discount model is that the
resulting valuation is not very sensitive to changes in the required rate of return assumption,
as we are looking at a potential takeover, it may be more appropriate to consider a free cash
flow model. The dividend discount model is most appropriate from the perspective of a
minority shareholder."