Microsoft Word - Money, Banking, and Int Finance(scribd).docx

Money, Banking, and International Finance

per year. Compute the rate of return on this investment. We calculate a rate of return of 8% per
year in Equation 23.

0.08

0.05

3

100

r=

r

$

$ =

^ (^23 )^

Some corporations, especially in high-tech industries, pay low dividends in the beginning.
Subsequently, the corporation grows rapidly over time, and it begins paying higher dividends.
We can modify the present value formula to handle this situation. Present value formula has two
components:

 Non-steady state – we use the present value to write out all cash flows, when the dividend

growth rate is not constant. Non-steady state occurs for a new corporation.

 Steady state – the corporation begins paying dividends over time that increase at a constant

rate. This occurs after the corporation becomes mature. Consequently, we calculate the

cash flows as a perpetuity.

As an illustration, we set the rate of return to 10%. A corporation pays a dividend of $6 at
time 1. Corporation expects to increase the dividend by 2% for the first year, 4% for the second
year, and 6% for year 3. After Year 3, the dividend grows at a constant rate of 6% per year. In
this case, we solve for the dollar value of the dividend for each year with no fixed growth rate.
We calculate the following:

 Year 1: D 1 = $6(1+0.02) = $6.12

 Year 2: D 2 = $6.12(1+0.04) = $6.3648

 Year 3: D 3 = $6.3648(1+0.06) = $6.746688

Third year becomes the perpetuity because the corporation begins increasing the dividend at
a constant rate. For this example, we must observe the time subscripts. Remember, we calculate
the stock price, P, one period before the dividend payment, D, in Equation 24.

168.67

0.10 0.06

3 6.746688

2 =$

$

=

r g

D

P=

 

( 24 )

Finally, we can calculate the market value of the stock share in the time period 0 by
discounting the future cash flows of the stock in Equation 25.