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Questions and Answers
What is the dividend growth rate of ABC Company?
What is the dividend growth rate of ABC Company?
What is the required rate of return for ABC Company?
What is the required rate of return for ABC Company?
Using the Gordon Growth Model, what formula represents the calculation for Po?
Using the Gordon Growth Model, what formula represents the calculation for Po?
What does the Gordon model primarily focus on in valuation?
What does the Gordon model primarily focus on in valuation?
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What does D1 represent in the formula Po = D1 / (r - g)?
What does D1 represent in the formula Po = D1 / (r - g)?
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In the Gordon model, which component represents the current dividend?
In the Gordon model, which component represents the current dividend?
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What is the value of the share (Po) calculated for ABC Company?
What is the value of the share (Po) calculated for ABC Company?
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What value is used in the Gordon model to signify the required rate of return?
What value is used in the Gordon model to signify the required rate of return?
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If an investor expects a firm’s dividend to grow at a rate of 5%, what is the term for this growth rate in the Gordon model?
If an investor expects a firm’s dividend to grow at a rate of 5%, what is the term for this growth rate in the Gordon model?
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If the required rate of return is higher than the growth rate of dividends, what implication does this have under the Gordon model?
If the required rate of return is higher than the growth rate of dividends, what implication does this have under the Gordon model?
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Study Notes
Stock Valuation
- Stock represents corporation fundraising
- Investors own CS share and receive dividends
- Stock valuation aims to determine the optimal selling price for a company's shares
- Constant growth model (Gordon model) estimates stock value based on constant dividend growth.
- Formula: P₀ = D₁ / (rₐ - g)
- P₀ = current stock price
- D₁ = next year's dividend
- rₐ = required rate of return
- g = constant growth rate
- Example: ABC Company's last dividend is 1.60, annual growth is 10%, and required rate is 16%. Stock value = 28.27 EGP
Capital Asset Pricing Model (CAPM)
- CAPM helps determine the required rate of return for an investment
- Formula: rⱼ = Rf + [βⱼ × (rm - Rf)]
- rⱼ = required return on asset j
- Rf = risk-free rate
- βⱼ = beta of asset j
- rm = market return
- Example: A corporation with a beta of 1.5, Rf = 12%, and rm = 16% has a required return of 18%.
- Market risk premium (rm - Rf) = 4%
- Security risk premium (βⱼ × (rm - Rf)) = 6%
Capital Budgeting and Cost of Capital
- Cost of capital is the minimum return needed for a capital budgeting project.
- It includes costs of equity financing and debt financing.
- Weighted average cost of capital (WACC) is the average of the cost of all capital sources
- Formula WACC = (w₁r₁) + (wp rp) + (ws rs)
- w₁ = weight of debt
- wₚ= weight of preferred stock
- wₛ= weight of common stock
- r₁ = cost of debt
- rp = cost of preferred stock
- rs = cost of common stock
Cost of Debt
- Company calculates the cost of debt considering interest payments.
- The after-tax cost of debt is calculated using the formula: rᵢ = rₐ x (1 - T), where rᵢ = after-tax cost of debt, rₐ = before-tax cost of debt, and T = tax rate.
Cost of Preferred Stock
- Cost of preferred stock (rp) is the ratio of the dividend to the price of preferred stock
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Description
Explore the key concepts of stock valuation and the Capital Asset Pricing Model (CAPM). This quiz covers essential formulas, including the Gordon growth model for stock pricing and how CAPM calculates the required rate of return for investments. Ideal for finance students looking to deepen their understanding of these foundational topics.
