1. Jonathan should explain that the price of common stock (or any assets for that matter) is equal to the discounted value of the future cash flow emanating from the asset, where the discount rate is the rate that investors require to bear the risk of owning that stock or asset. In the case of common stock, investors expect to receive dividends from the stock either in the short run or at some point in the future. Thus, discounting the forecast dividend which is what the dividend discount model does, would be a logical method of calculating the justifiable price of common stock.
2. Growth rate can be determined by calculating the average compound rate of growth of the dividend or earning between two time periods. For example, as per table 1 in 1995, the dividend per share was $0.6 and in 2004 the dividend had increase to $0.94 per share.
PV=-$0.60 ; FV=0.94; N=9;PMT=0;CPT 1=5.11%-- GROWTH RATE
3. The required rate of return is based on securiity market line equation, which is as follow :
Where risk-free rate is what an investor can earn with almost certainty. The average risk premium is the different between the rate expected on the market index. Beta is a measure of the systematic risk of the stock. It is a measure of the sensitivity of the stok return to the market index return. Thus, the equations says that an investor must earn at least the rick free rate plus the proportional risk premium over and above the risk free rate.
REQUIRED RATE OF RETURN FOR PCU = 5.1 % + (9%)*1.1 = 15%
4. “What other variations of the DDM can one use and Why?” asked Dwayne. What should Jonathan’s response be?
Jonathan’s response should be like this, “The other variation of the DDM can one use is by calls for recognizing that the dividend payments may grow as a small but constant rate. With this approach, the equity of the company is considered to be a perpetuity. Understanding which scenario is applicable to the stock under consideration is very...