Case 78 James River

1. According to ValueLine estimates in Figure1, James River’s expected annual dividend growth rate from the 91-93 to 97-99 period is 5.50%, and the next dividend (1995) is expected to be $0.60. Assume that the required return for James River was 8.36% on January 1 1995 and that the 5.50% growth rate was expected to continue indefinitely.

A. Based on the Constant Growth Rate or Gordon Model, What was James River’s price at the beginning of 1995?

James River’s Price was $20.98 at the beginning of 1995.

B. What conditions must hold to use the constant growth model? Do many “real world” stocks satisfy the constant growth assumptions?

The constant growth model requires that dividends grow at a constant rate forever.

No many “real world” stocks do not satisfy the constant growth assumptions. This is because in the real world things can be volatile and harder to predict so being able to continually grow your business at a certain rate each year is difficult.

2. The Wall Street Journal (WSJ) lists the current price of James River common stock at $27.00.

A. Based on this information, the ValueLine 1995 expected dividend and the annual rate of dividend change for the growth estimate, what is the company’s return on common stock using the constant growth model? What is the expected dividend yield and expected capital gains yield? Explain the difference in the required return estimates from the ValueLine (see question 1a) to the WSJ price data.

The expected return is 7.72%

The expected dividend yield =.6/27=2.22% and the capital gains yield is the growth rate of 5.50%.

The most likely reason the required return estimates have decreased and the price of the stock has increased is because people believe that the company has less risk now than it did when ValueLine estimates were released.

B. What is the relationship between dividend yield and capital gains yield over time under constant growth assumptions?

The dividend yield and capital gains yield would...