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1 Critically evaluate the Dividend Discount Model approach to share valuation 2 Trevi Corporation recently reported an EBITDA of $33,000 and $9,500 of net income
1
Critically evaluate the Dividend Discount Model approach to share valuation
2
Trevi Corporation recently reported an EBITDA of $33,000 and $9,500 of net income. The company has $6,600 interest expense, and the corporate tax rate is 35 percent. What was the company’s depreciation and amortization expense? Round to the nearest cent.
3
What are the components of the required rate of return on a share of equity? Briefly explain each component
Expert Solution
1
The dividend discount model (DDM) is an approach that is used to value the price of the equity shares. It predicts the current value of the company's equity stock by calculating the sum of all of its future dividend payments discounted at their present value. The discount rate is usually the interest rate currently prevailing.
An entity earns profit which is the primary indicator of the company’s stock prices. All the equity share holders of the company have a right on the profits earned by the entity; as a result they receive dividends from the shareholders. The Dividend Discount Model assumes that the value of a company is measured by the present worth of all its future payments.
Future Value is calculated as Present Value ∗(1+interest rate% )
This method is advantageous because it is based on the dividend payments. Dividend is the consistent indicator and most reliable source of measuring the growth and financial health of the company.
It just has disadvantages that this model is based on lots of assumptions and is theoritically considering just dividend as an indicator of financial health measurement. There may be other factors which remain overlooked in this process.
2
| Earnings before tax |
| Earnings before tax = Net Income / (1 - Tax rate) |
| Earnings before tax = $9,500 / (1 - 0.35) |
| Earnings before tax = $9,500 / 0.65 |
| Earnings before tax = $14,615.38 |
| EBIT |
| EBIT = Earnings before tax + Interest expenses |
| EBIT = $14,615.38 + $6,600 |
| EBIT = $21,215.38 |
| EBITDA |
| EBIT = EBITDA - Depreciation and amortization |
| $21,215.38 = $33,000 - Depreciation and amortization |
| Depreciation and amortization = $33,000 - $21,215.38 |
| Depreciation and amortization = $11,784.62 |
| Therefore, the company’s depreciation and amortization expense will be $11,784.62 |
3
When we are trying to calculate the required rate of return on equity, then we will be trying to calculate the required rate of return on equity through Capital Asset pricing model which will be determining the risk-free rate which our existing in the economy and it will be trying to ascertain the beta of the company and beta of the company will be representative of all the systematic risk which are involved with the company and beta of the company will be adjusted with the risk premium which currently existing in the economy and beta of the company will be adjusted with the risk premium by multiplying the beta and risk premium and then it will be trying to add the risk-free rate in order to arrive at the required rate of return.
A. Risk free rate of return generally reflective of the rate of return which will be earned without taking any risk.
B. Risk premium of the market will be reflecting the difference between risk free rate and the market rate of return and it will be adjusted with the beta of the company.
C. Beta of the company will be representative of the systematic risk which are involved with the operations of the company.
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