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How Low Can It Go?

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    4. “What other variations of the DDM can one use and Why? ” asked Dwayne. What should Jonathan’s response be? Jonathan’s response should be like this, “The other variation of the DDM can one use is by calls for recognizing that the dividend payments may grow as a small but constant rate. With this approach, the equity of the company is considered to be a perpetuity. Understanding which scenario is applicable to the stock under consideration is very important, as it will impact how the dividend payment relates to the company’s equity.

    The reason of this variations are ways to account for factors that are unique to the company in question, and how those factors impact the equity of the company. Because the model can be calculated using various data above and beyond the basic models, not all financial analysts consider this approach to be especially helpful. ” 5. “Why are you using dividends and not earnings per share, Jonathan? ” asked Dwayne. What do you think Jonathan would have said?

    I think Jonathan would said that the dividends per share are usually easily found on quote pages as the dividend paid in the most recent quarter which is then used to calculate the dividend yield. Dividends over the entire year (not including any special dividends) must be added together for a proper calculation of dividends per share, including interim dividends. Special dividends are dividends which are only expected to be issued once so are not included.

    The total number of ordinary shares outstanding is sometimes calculated using the weighted average over the reporting period. While earnings per share is generally considered to be the single most important variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings valuation ratio. Not only that, the most common use of earnings per share is to calculate the PE ratio, which puts earnings per share into context by comparing it to the share price.

    There are a number of variants of the PE ratio, using past earnings, forecast earnings, or the average over many years. 6. Dwayne wondered whether Pharmacopia’s preferred stock would be a better investment than its common stock, given that it was paying a dividend of $1. 5 and trading at a price of $15. He asked Jonathan to explain to him the various features of preferred stock, how it differed from common stock and corporate bonds, and the method that could be used for estimating its value.

    The various features of preferred stock are usually (i) preference to dividends, (ii) preference to assets in the event of liquidation, (iii) convertible into common stock, (iv) callable at the option of the corporation and (v) nonvoting. The preferred stock is differed from common stock when a company goes bankrupt, preferred stockholders enjoy priority distribution of the company’s assets, while holders of common stock don’t receive corporate assets unless all preferred stockholders have been compensated (bond investors take priority over both common and preferred stockholders).

    Meanwhile, the preferred stock is differed from corporate bonds because they are vary in price for different reasons. If company earnings grow, the stock is almost certain to rise over time. The price of bonds depends on the prevailing interest rates. If interest rates rise, a bond becomes less attractive because it pays a fixed rate and the price will fall. Conversely, if interest rates fall, the bond price is likely to rise. Bonds are rated based on risk (how likely it is the issuer will be able to repay the bond at maturity).

    A reduced rating will usually cause the bond’s price to fall. The value of preferred stock is basically a perpetuity. Since the preferred dividends are generally fixed, preferred stock can be valued as a constant growth stock with a dividend growth rate equal to zero. Thus, the price of a share of preferred stock can be determined using the following equation: where •Pp = the preferred stock price, •Dp = the preferred dividend, and •r = the required return on the stock.

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