The Dividend Growth Model

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There are a few different inputs into the dividend growth model. P0 is the price of the company's stock today. This factors into the model because the price of the stock in this model is taken to be the value of the discounted future cash flows. Those cash flows come entirely from dividends in this model. Thus, the higher the price, the greater the value of those future cash flows. The higher the price, the lower the cost of capital for the company. D1 is the current dividend. This is the present cash flow that will be extrapolated out into the future. The higher the current dividend, the higher the rate of return on the equity. The g is the growth rate of the dividend. The higher the growth rate of the dividends, the higher the rate of return will be. As we know, the higher the risk of the cash flows (the discount rate), the less likely the project will have a positive NPV and thus the less likely the project will be accepted. A higher Re, or discount rate, the riskier the project will need to be in order to be accepted, because a higher discount rate implies that for the company the opportunity cost of capital is higher (riskier). A higher stock price implies that the company is less risky. Yet, the higher the current dividend or the dividend growth rate, the riskier the company will be. The security market line approach (aka CAPM) is another method of determining the firm's cost of equity. The SML equation is as follows: Source: PowerPoint The risk free
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