Friday, April 2, 2010


The Dividend Growth Model: Supernormal Growth

A firm may pass through different phases of growth. Hence, dividend may growth at different rates in the future. The growth rate may be very high for a few years, and afterwards, it may become normal indefinitely in the future. The dividend valuation model can also be used to calculate the cost of equity under different growth assumptions.

For example, if the dividends are expected to grow at a super normal growth rate gs, for n years and thereafter, at a normal, perpetual growth rate of, gn, beginning in year n+1, then the cost of equity can be determined by the following formula:

Po = ((1+gs)1/(1+Ke)1) + ((1+gs)1/(1+Ke)1) +-------------+((1+gs)t/(1+Ke)t) + (Pn/ (1+Ke)n)

Pn is the discounted value of the dividend stream, beginning in year n+1 and growing at a constant, perpetual rate gn at the end of year n, and therefore it is equal to:

Pn = DIV n+1 / Ke – gn

When we multiply Pn by 1(1+Ke) n we obtain the present value of Pn in year 0.

Po = (DIVo (1+gs)1)/ (1+Ke)1 + (DIV1 (1+gs)1)/ (1+Ke)1 +-----------+(DIVn (1+gs)t)/ (1+Ke)t + ((DIV n+1/(Ke – gn) X (1/ (1+Ke)n

The cost of equity, Ke, can be computed by solving above equation by trial and error.

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