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Hello,
I would like to know why we deduct growth from required return in dividend valuation model.What is the interpretation of it.
The formula is Po= Do (1+g) / Re-g
Sir I would also like to know that
Financial risk which means that the company is highly geared is an aspect of systematic risk which is specific to the market as written in the bpp. While systematic risk is non-diversifiable.
If we are investing in a company so we have diversified the financial risk. So shouldn’t it be considered as part of unsystematic risk which is only company specific.
I would be waiting for your prompt reply.
Thank you so much
Although it is possible to prove the formula (the market value is the present value of future expected dividends discounted at the shareholders required rate of return – it is like an inflating perpetuity), it is given in the exam and you are not required to prove it.
However there is some logic to it. If there was a constant dividend, then Po – Do / Re.
However since the dividend is growing, you would expect the market value to be bigger, and dividing by Re – g will give a bigger market value. (This is obviously not proving the formula, but at least it should that there is some sense in it.)@saline said:
Sir I would also likeexams/forum/topic/dividend-valuation-model-1/#post-91956’>said:
Sir I would also like to know that
to know thatFinancial risk which means that the company is highly geared is an aspect of systematic risk which is specific to the market as written in the bpp. While systematic risk is non-diversifiable.
If we are investing in a company so we have diversified the financial risk. So shouldn’t it be considered as part of unsystematic risk which is only company specific.
I would be waiting for your prompt reply.
Thank you so much
Financial risk is due to the fixed interest payments on borrowing, and these always make a share more risky in all respects.
If we ignore the financial risk, then the risk is due to two things – the type of business (this is the systematic risk) and factors peculiar to the company (this is the unsystematic risk).
If we are diversified, then the unsystematic risk disappears and so we are only concerned with the systematic risk, and it is this that determines the return required.
If there is gearing in the company, then we are still only concerned with the systematic risk, but the effect of the gearing is to make this risk greater, and therefore we will require a higher return.
Have you watched the lecture on CAPM?
Sir,
thank you for above explanation, I have still question regarding below BPP statement.The financial risk is an aspect of systematic risk and ought to be reflected in the beta factor used to evaluate a specific project.
Why financial risk is aspect of systematic risk not unsystematic risk. If financial risk is due to gearing and gearing is specific to the company?
I did watch lecture but still would like to clarify it.
Thank you in advance for your help.
Financial risk multiplies the existing risk – it is not simply extra risk that is added on.
(Look again at the lecture working through example 1 in Chapter 13 of the lecture notes).More gearing simply increases the existing systematic risk, and increases therefore the beta factor of the equity.
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