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FIN622 GDB Solution Spring 2017

Question:

Dividend discount model is a widely used common stock valuation technique suitable for stocks of companies paying all or some of their earnings in the form of dividends to their shareholders.

Firms which pay all their earnings in the form of dividends have zero growth rate (g=0) since they have nothing to reinvest from their earnings in profitable opportunities. It is argued in relevant empirical studies that such firms which pay all their earnings as dividends have less current stock value as compared to those that retain some portion of their earnings to plowback in business. This is because retained earnings are then reinvested in business in available profitable opportunities to earn an expected return that ultimately increase current stock price. The return expected on retained earnings is different from the rate of return required by investors (r). This expected return on plow back (retained) earnings is then multiplied with the retention ratio of companies to determine their growth rate. In real situation, the relationship between retained earnings to reinvest in business and current stock price is bit complex. Retaining some portion of earnings to reinvest in business can have positive, negative or no effect on current stock price of a firm.

Requirement:

Considering the components of Dividend Discount Model (DDM), discuss how plowing back some portion of earnings into business can:

  1. Increase the current stock price.
  2. Decrease the current stock price.
  3.  Have No effect on current stock price.
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