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101 Concepts for the Level I Exam

Concept 76: Dividend Discount and Free-Cash-Flow-to-Equity Models


Dividend discount model: Value is estimated as the present value of expected future dividends plus the present value of a terminal value.

     $$V_0\ =\ \sum^n_{t=1}{{{D^t}\over {{\left(1+r\right)}^t}}+{{P^n}\over {{\left(1+r\right)}^n}}}$$

A stock paid a $10 dividend last year. The next year’s dividend will be 8% higher and the stock will sell at $150 at year-end. Calculate the value of this stock if the required rate of return is 12%.

Solution:

D1 = D0 x (1 + dividend growth rate) = $10 x 1.08 = $10.8

     $$V_0\ =\ {{\$10.8}\over {1.12}}+{{\$150}\over {1.12}}=\$143.57$$

Free cash flow to equity model: Value is estimated as the present value of expected future free cash flow to equity. FCFE is the cash available to the firm’s equity holders after a firm meets all its other obligations.

FCFE = CFO – FCInv + Net borrowing

     $$V_0=\sum^{\infty }_{t=1}{{{FCFE^t}\over {{\left(1+r\right)}^t}}}$$

Estimating the required rate of return for equity: CAPM is often used to calculate the required rate of return for a security.

Required rate of return = risk free rate + β [market risk premium]