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2Notice that if we have D0 and g, we can simply calculate D1 by multiplying D0 by (1 + g).

2Notice that if we have D0 and g, we can simply calculate D1 by multiplying D0 by (1 + g).

Ross et al.: Fundamentals I VI. Cost of Capital and I 15. Cost of Capital I I © The McGraw-Hill of Corporate Finance, Sixth Long-Term Financial Companies, 2002

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CHAPTER 15 Cost of Capital 497

Notice that we calculated the change in the dividend on a year-to-year basis and then expressed the change as a percentage. Thus, in 1999 for example, the dividend rose from $1.10 to $1.20, an increase of $.10. This represents a $.10/1.10 = 9.09% increase.

If we average the four growth rates, the result is (9.09 + 12.50 + 3.70 + 10.71)/4 = 9%, so we could use this as an estimate for the expected growth rate, g. There are other, more sophisticated, statistical techniques that could be used, but they all amount to using past dividend growth to predict future dividend growth.

Advantages and Disadvantages of the Approach The primary advantage of the dividend growth model approach is its simplicity. It is both easy to understand and easy to use. There are a number of associated practical problems and disadvantages.

First and foremost, the dividend growth model is obviously only applicable to companies that pay dividends. This means that the approach is useless in many cases. Furthermore, even for companies that do pay dividends, the key underlying assumption is that the dividend grows at a constant rate. As our previous example illustrates, this will never be exactly the case. More generally, the model is really only applicable to cases in which reasonably steady growth is likely to occur.

A second problem is that the estimated cost of equity is very sensitive to the estimated growth rate. For a given stock price, an upward revision of g by just one percentage point, for example, increases the estimated cost of equity by at least a full percentage point. Because D1 will probably be revised upwards as well, the increase will actually be somewhat larger than that.

Finally, this approach really does not explicitly consider risk. Unlike the SML approach (which we consider next), there is no direct adjustment for the riskiness of the investment. For example, there is no allowance for the degree of certainty or uncertainty surrounding the estimated growth rate for dividends. As a result, it is difficult to say whether or not the estimated return is commensurate with the level of risk.3

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