Page 304 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes The model may be written:

Div. Curr.
Value of the share =
CR  (CR )(%RE)
norm act
Where Div. Curr = Current Dividend in rupees (annual basis)
CR = Capitalization rate demanded by the market for the stock of the type.
norm
CR = Actual capitalization rate based on the firms current earnings
act
(provided they are relatively normal) and current market price.
%RE = Percentage of Future earnings, the firm is likely to retain.
The dividend growth model shows the value of a share as the shares current dividend divided
by the amount that the demanded profit exceeded the rate of growth in the dividend, stated
graphically. The model shows value as:

Current dividend
Value of the share =
Demanded after tax profit  dividend growth

Example: If a firm has a 10% actual capitalization rate, a dividend payout of 40% and
declares a 1 dividend in 2005. What is the growth rate? What is the likely stream of dividends
through 2009? If the firm is in industry with a 12% normal capitalization rate, what is the
intrinsic value using the dividend growth model?
Solution: Multiplying the actual capitalization rate by the percentage of retained earnings gives
the growth rate in dividend per share, assuming no change in dividend payout.
The firm retains a 60% share of the 10% post-tax profits for a 6% growth rate. The stream of
dividend payments at a 6% growth rate is as follows:
Year 2005 2006 2007 2008 2009
Dividend factor 1.06 (1.06) 2 (1.06) 3 (1.06) 4
Dividend 1 1.06 1.12 1.19 1.26

1 1
Value of the share =   16.67
12%  (10%)(60%) 0.06

Factors Incorporated in the Dividend Growth Model
1. Restriction of the shareholders’ return to a single variable: In this model the income factor
is limited to the current dividend earnings retained in the firm are part of the growth
factor that will operate to increase the current dividend, but only the dividend and its
expected increases are considered as a return.

2. Inclusion of two capitalization rates:
(a) Normal Capitalization Rate (CRnorm) i.e., reciprocal of PE ratio: If the firm is not able to
achieve such a return at the existing market price, shareholders will sell their shares,
thus depressing the market price and raising the rate of return.
(b) Actual Capitalization Rate: The firm’s actual capitalization rate is the relationship of its
actual EPS to the market price of its stock. This is an important factor influencing
growth. A firm with higher profits will have more funds to retain and hence more
money to finance growth, as compared with firms with lower profits.

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