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The part (b) uses dividend valustion model to calculate the upper range of issue prices. It involves three possible earnings rates.
(1) the historical earnings growth rate of 12%: I don’t know why it is rejected because of being greater than cost of equity capital and why it is compared to Ke rather than WACC
(2) the weighted anticipated growth rate of 5.34%: does it mean the growth rate of dividend is equal to the growth rate of earnings.For (1) remember that in theory the market value is determined using the dividend valuation model. If you were to put growth as 12% in the dividend valuation formula, then if Re (cost of equity) is lower than 12% then it isn’t going to work 🙂
For (2) in the long-term, dividend growth should depend on earnings growth because in the long-term it is the level of earnings that determines the level of dividends.
Oh,I understand it. Because it is the growth of earnings that determines the growth of dividend, g in the DVM is 12%. And P0=D0(1+g)/(Ke-g), to ensure P0 >0, (Ke-g)must be positive, so Ke >g.
Thanks! John, you help me a lot.
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