Chapter 18, Problem 1PS

Summary Introduction

To describe: The circumstances in which the dividend discount model can be used instead of free cash flow model to value a firm.

Introduction:

Dividend discount model: DDM, in short, is one of the firm’s valuation method. It is found to be similar to discounted cash flow valuation methods. DDM mainly focuses on dividends. The stock is computed on the basis of dividends which are predicted in advance and then these dividends are discounted back to know their present value.

Answer to Problem 1PS

The stability of cash inflows, reliability, applicability, issuance of dividend and potentiality are some of the circumstances in which usage of DDM proves to be fruitful.

Explanation of Solution

The valuation of the firm in terms of success, progress, and financial stability is a must and has to be done by every company. There are many methods to value a firm. The popular valuation methods are dividend discount model and free cash flow models. Both of these models deal with discounting of future cash flows at a required rate of return which has a chance of occurring to a firm. Normally future cash flows derived may be in the form of dividends or capital gains and this amount is derived at the time of selling the stock.

Even though both the methods mentioned above are very useful in the valuation of a firm, there are many circumstances in which the dividend discount model is preferred more than the free cash flow model. Let us list some of the circumstances:

☐ Stability of cash flows: When we consider the firm’s stability in respect of cash flows sometimes valuation of the firm may not be easy. But when the dividend discount model is used for calculation, the forecast of dividends may be easy. Dividends are the amount received as income without selling any type of stock. Therefore, the value of the firm will be equal to the never-ending stream of dividends. The logic utilized in DDM is clear and does not entertain any hidden information.

☐ Reliability: Reliability is one of the main aspects which attract investors. Even though there are many ups and downs in the firm, a firm pays dividends to its investors based on the cash availability of the firm. This is checked every year and only then it is announced that certain dividends will be issued to the investors. Therefore, the income in the form of dividend is certain and no false promises are made to the investors unnecessarily.

☐Applicability: The need to check a firm’s growth rate and the market capitalization rate is a must. DDM is applicable to those firms whose growth rate is less than the market capitalization rate.

☐ Issuance of Dividend: If a firm is not issuing the dividends, the application of DDM model is useless. DDM model mainly depends on the dividends and when no dividends are issued, the valuation of the firm using DDM model is useless.

☐ Potentiality: When a firm is its initial stage or startup stage, it may have huge investment needs and it also may have a high growth potentiality. In such a cash, forecast of dividends will not be possible. Hence usage of DDM model to value the firm is not advisable.