Questions

1. According to ValueLine estimates in Figure 1, James River’s expected annual dividend growth rate from the 91–93 to 97–99 period is 5.50%, and the next dividend (1995) is expected to be $0.60. Assume that the required return for James River was 8.36% on January 1 1995 and that the 5.50% growth rate was expected to continue indefinitely.

a. Based on the Constant Growth Rate or Gordon Model, what was James River’s price at the beginning of 1995?

Price = [pic]

b. What conditions must hold to use the constant growth model? Do many “real world” stocks satisfy the constant growth assumptions?

In order to use the constant growth model, we must assume that the dividends will grow at a constant rate and they must continue forever. There is also an assumption that the required return on common equity must be greater than the expected growth rate of the dividend. The constant growth model is probably the most used model in practice, however, not many “real world” stocks will satisfy all the assumptions. It is still a good estimate of the price.

2. The Wall Street Journal (WSJ) lists the current price of James River common stock at $27.00.

a. Based on this information, the ValueLine 1995 expected dividend, and the annual rate of dividend change for the growth estimate, what is the company’s return on common stock using the constant growth model? What is the expected dividend yield and expected capital gains yield? Explain the difference in the required return estimates from the ValueLine (see question 1a) to the WSJ price data.

The company’s return on common stock using the constant growth model is 7.72%. The expected dividend yield is [pic]. The expected capital gains yield is the difference of the total yield, 7.72%, and the dividend yield of 2.22%, which give us 5.5% for the expected capital gains yield. Since the required return in question 1a was 8.36% and the required...