MASTER OF BUSINESS ADMINISTRATION

SEMESTER II

Name Roll No Learning Centre Subject Date of Submission

: : : : :

Arun John 571014389 Isaacs Info school,Aluva Financial Management(MB0045) 27.09.2011

Masters of Business Administration Semester 2 MB0045 Financial Management

Assignment Set- 1
Q1. A company has issued a bond with face value of Rs.1000 , with 10% pa coupon rate payable annually and a tenure of 10 years to maturity. At the end of 10 years, the bond will be redeemed at a premium of 10% to face value . a) At what price would you buy the bond if the prevailing interest rate is 12% pa on investments of similar risk? b) What is the YTM of the bond if the prevailing price is same as calculated in a) above. c) What is the current yield of the bond at the given price? d) If the coupon rate is paid semi-annually, at what price would you buy the bond at the 12% pa prevailing interest rate?

a) PVIFA(Kd,n) = [(1 + Kd)n - 1 ] / [Kd (1 + Kd) n] PVIFA(12%,10) = [(1+0.12)10 -1] / [0.12(1+0.12) 10] = [(1.12) 10 -1] / [0.12(1.12) 10] = 2.11 / 0.37 = 5.70 coupan rate I = 10% face value = 1000 So, I = 1000 * 10 % = Rs 100 Value of Bond Vo = I * PVIFA(Kd,n) + F/(1+Kd) n = 100 * 5.70 + 1000/ (1.12)10 = 570 + 1000/ 3.10 = 570 + 322.58 = 892.58 b) YTM = {I + (F-P)/n} / {(F+P)/2} I = 100 , F = 1120 , P= 892 = { 100 + (1000 892) / 10} / {(1000+892) / 2} = 110.8 / 946 = 11.7 % c) Current Yield = coupan Interest / current market price coupan Interest= 1000 * 10% = 100 current market price = 892 current Yield = 100 / 892 = 11.21 % d) Vo = (I / 2) / (1 + Kd/2)n + F / (1 + Kd/2)2n = ( 100 /2 ) / (1+ 0.12/2)10 + 1000 / (1+ 0.12/2)2*10 = 50 / 1.79 + 1000 / 3.20 = 27.93 + 312.5 = 340.43

Q2. Given the following details for a company: Net operating income 200,000 Overall cost of capital 20% Value of the firm 1000,000 Cost of debt 15% Interest 75,000 Market value of debt 500,000 Market value of equity 500,000 a) Given the assumptions of the net operating income approach, what will be the cost of equity, if the market value of debt is 200,000. b) Given the assumptions of the net income approach, what will be the overall cost of capital with Market value of debt of 200,000. 2 NET OPERATING INCOME =200000 LESS INTEREST ON DEBT = 105000 EARNINGS AVAILABLE ON RATE I.E=95000 MARKET VALUE OF EQUITY =500000 =595000 MARKET VALUE OF DEBT=500000 TOTAL VALUE OF FIRM=1095000 OVERAL COST OF CAPITAL=7.6% Q3. Given the following projects , rank them on the basis of NPV, MIRR and Payback period if the cost of capital is 10% pa.

PARTICULAR

TIME

PVF

CASH OUTFLOW PVCO(A) CASH INFLOW

PROJECT PV A AMOUN T -10000 10000 -10000 5000 4545 7000 5782 8000 6008 15000 10245 TOTAL 26580 36580

PROJECT PV B AMOUN T -10000 10000 -10000 5000 4545 8000 6608 6500 4881.5 11000 7513 TOTAL 23547.5 33547.5

PROJECT PV C AMOUN T -10000 10000 -10000 5000 4545 8500 7021 9000 6754 12000 8196 TOTAL 26516 36516

1 2 3 4 PVCI(B) NPV(B)-(A)

0.909 0.826 0.751 0.683

Q4. Given the following information, calculate Degree of operating leverage, Degree of Financial leverage, Degree of total leverage. Quantity sold 100,000 units Variable cost per unit 200 Selling price 800 Fixed cost 10,000 Number of equity shares 50,000 Debt 1000,000 @ 15%pa Preference shares 10,000 of Rs.100 each @ 10% Tax rate 30% sale = 80000000 (-)vc = 20000000 Contribution=60000000 (-) Fc=10000 EBIT=59990000 (-) Interest=150000 EPT=59840000

Degree of operating leverage= Contribution/ EBIT =60000000/59990000=1.00016 Degree of Financial Leverage=EBIT/EBT =59990000/59840000=1.0025 Degree of total leverage= OLFL=1.0026 Q5. Explain the following concepts : a) Operating cycle b) Total inventory cost c) Price earnings ratio d) Financial risk a) Operating cycle: It is the time period involved in the conversion of raw material/resources into finished goods or services including the credit period involved for selling products/services. In simple language. let me give you an extreme example Suppose a business buy raw material on 1st jan and it takes one month to convert this raw material into finished goods. On 1st feb good are ready for sale i.e. stocked at warehouse on 1st march goods are sold and on 1st april payment is received. Now this revenue will be used to buy fresh raw material. The average time it takes for a retailer's or manufacturer's inventory to turn to cash. If a manufacturer turns its inventory six times per year (every two months) and allows customers to pay in 30 days, its operating cycle is approximately three months. Expressed as an indicator (days) of management performance efficiency, the operating cycle is a "twin" of the cash conversion cycle. While the parts are the same - receivables, inventory and payables - in the operating cycle, they are analyzed from the perspective of how well the company is

managing these critical operational capital assets, as opposed to their impact on cash. Formula:

b) Total inventory cost: Total Inventory cost is the total cost associated with ordering and carrying inventory, not including the actual cost of the inventory itself. It is important for companies to understand what factors influence the total cost they pay, so as to be able to minimize it. Use the total inventory cost calculator below to solve the formula. Total Inventory Cost is the sum of the carrying cost and the ordering cost of inventory. Variables C=Carrying cost per unit per year Q=Quantity of each order F=Fixed cost per order D=Demand in units per year

c) Price earnings ratio: The P/E ratio (price-to-earnings ratio) of a stock (also called its "P/E", or simply "multiple") is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. Unlike EV/EBITDA multiple, P/E reflects the capital structure of the company in question. P/E is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio. The P/E ratio has units of years, which can be interpreted as "number of years of earnings to pay back purchase price", ignoring the time value of money. In other words, P/E ratio shows current investor demand for a company share. The reciprocal of the P/E ratio is known as the earnings yield. The earnings yield is an estimate of expected return to be earned from holding the stock if we accept certain restrictive assumptions (a discussion of these assumptions can be found here). d) Financial risk: Financial risk is an umbrella term for any risk associated with any form of financing. Risk may be taken as downside risk, the difference between the actual return and the expected return (when the actual return is less), or the uncertainty of that return. Risk related to an investment is often called investment risk. Risk related to a company's cash flow is called business risk. A science has evolved around managing market and financial risk under the general title of modern portfolio theory initiated by Dr. Harry Markowitz in 1952 with his article, Portfolio Selection. Credit risk, also called default risk, is the risk associated with a borrower going into default (not making payments as promised). Investor losses include lost principal and interest, decreased cash flow, and increased collection costs. Investment risk has been shown to be particularly large and particularly damaging for very large, one-off investment projects, so-called "megaprojects". This is because such projects are especially prone to end up in what has been called the "debt trap," i.e., a situation where due to cost overruns, schedule delays, etc. the costs of servicing debt becomes larger than the revenues available to pay interest on and bring down the debt Q6. Explain the Net operating income approach to capital structure theories. The second approach as propounded by David Durand the net operating income approach examines the effects of changes in capital structure in terms of net operating income. In the net income approach

discussed above net income available to shareholders is obtained by deducting interest on debentures form net operating income. Then overall value of the firm is calculated through capitalization rate of equities obtained on the basis of net operating income, it is called net income approach. In the second approach, on the other hand overall value of the firm is assessed on the basis of net operating income not on the basis of net income. Hence this second approach is known as net operating income approach. The NOI approach implies that (i) whatever may be the change in capital structure the overall value of the firm is not affected. Thus the overall value of the firm is independent of the degree of leverage in capital structure. (ii) Similarly the overall cost of capital is not affected by any change in the degree of leverage in capital structure. The overall cost of capital is independent of leverage. If the cost of debt is less than that of equity capital the overall cost of capital must decrease with the increase in debts whereas it is assumed under this method that overall cost of capital is unaffected and hence it remains constant irrespective of the change in the ratio of debts to equity capital. How can this assumption be justified? The advocates of this method are of the opinion that the degree of risk of business increases with the increase in the amount of debts. Consequently the rate of equity over investment in equity shares thus on the one hand cost of capital decreases with the increase in the volume of debts; on the other hand cost of equity capital increases to the same extent. Hence the benefit of leverage is wiped out and overall cost of capital remains at the same level as before. Let us illustrate this point. If follows that with the increase in debts rate of equity capitalization also increases and consequently the overall cost of capital remains constant; it does not decline. To put the same in other words there are two parts of the cost of capital. One is the explicit cost which is expressed in terms of interest charges on debentures. The other is implicit cost which refers to the increase in the rate of equity capitalization resulting from the increase in risk of business due to higher level of debts. Optimum capital structure This approach suggests that whatever may be the degree of leverage the market value of the firm remains constant. In spite of the change in the ratio of debts to equity the market value of its equity shares remains constant. This means there does not exist a optimum capital structure. Every capital structure is optimum according to net operating income approach.

Masters of Business Administration Semester 2 MB0045 Financial Management

Assignment Set- 2

Q1. Given the following information, prepare a cash budget: Month Sales Purchases Wages Production overheads Jan 100000 40000 10000 6000 Feb 120000 45000 15000 6500 March 150000 35000 18000 7000 April 160000 30000 20000 7700 May 175000 25000 22000 8000 June 200000 20000 24000 8500

Selling overheads 6000 6500 6600 6800 6200 6300

The company has a policy of selling its goods at 50% cash and the balance on credit. On credit sales, 50% is paid in the following month and balance 50% two months from the sale. Purchases are paid one month from the month of purchase. Wages are paid in the following month and overheads are also paid in the following month. The company plans a capital expenditure, in the month of April, for Rs. 25,000. The company has a opening balance of cash of Rs. 40,000 on 1st Jan 2010. Prepare a cash budget for Jan to June.
Particulars Opening cash balance Cash receipts: Cash sales Credit sales Total cash available Cash payments Materials Wages Production overheads Selling overheads Purchase of asset Total cash payments Closing cash balances Jan 40000 50000 90000 Feb 90000 60000 25000 175000 40000 10000 6000 6000 0 90000 62000 113000 March 113000 75000 55000 243000 45000 15000 6500 6500 73000 170000 April 170000 80000 67500 317500 35000 18000 7000 6600 25000 91600 225900 May 225900 87500 77500 390900 30000 20000 7700 6800 64500 326400 June 326400 100000 83750 510150 25000 22000 8000 6200 61200 448950

Working Notes: Credit Sales Calculation

Month Monthly Sales Cash Sales Credit Sales

Jan 100000 50000

Feb 120000 60000 25000 - Jan

Mar 150000 75000 25000 - Jan 30000 - Feb

Apr 160000 80000 30000 - Feb 37500 - Mar

May 175000 87500 37500 - Mar 40000 -

Jun 200000 100000 40000 April 43750 -

Receipts

50000

85000

130000

147500

April 165000

May 183750

Q2. Given the following information in terms of per unit costs, prepare a statement showing the working capital requirement. Raw material Direct labour Overheads Total cost Profit Selling price 60 22 44 126 18 140

The following additional information is available: Average raw material in stock one month Average materials in process 15 days Credit allowed by suppliers one month Credit allowed to debtors two months Time lag in payment of wages 15 days Time lag in payment of overheads one month Sales on cash basis 20% Cash balance to be maintained 80,000 You are required to prepare a statement showing the working capital required to finance a level of activity of 100,000 units of output. You may assume production is carried out evenly throughout the year and payments occur similarly. Assume 360 days in a year.

As the annual level of acitivity is given at 1,00,000 units, it means that the monthly turnover would be 1 , 0 0 ,000/12=8,333 units. The working capital requirement for this monthly turnover can now be estimated as follows : Estimation of Working Capital Requirements 1 Current Assets : Amount (Rs.) Amount (Rs.) Minimum Cash Balance 80,000 Inventories : 5,00,000 Raw Materials (8,333Rs. 6 0) Work-in-progress : 2,50,000 Materials (8,333Rs. 6 0)/2 Wages 50% of (8,333Rs. 22)/2 45,833 Overheads 50% of (8,333Rs. 44)/2 91,667 Finished Goods (8,333Rs. 126) 10,50,000 Debtors (8,333Rs. 12680%) 8,40,000 28,57,500 Gross Working Capital 28,57,500

II

Current Liabilities : Creditors for Materials (8,333Rs. 6 0) Creditors for Wages (8,333Rs. 22)/3 Creditors for Overheads (8,333Rs. 44) Total Current Liabilities Net Working Capital

5,00,000 61,111 3,66,667 9,27,778

9,27,778 19,29,722

Working Notes : For Calculations Monthly Turnover is taken as 8,333.33 In the valuation of work-in-progress, the raw materials have been taken at full requirements for 15 days; but the wages and overheads have been taken only at 50% on the assumption that on an average all units in work-in-progress are 50% complete. 3 . Since, the wages are paid with a time lag of 10 days, the working capital provided by wages has been taken by dividing the monthly wages by 3 (assuming a month to consist of 30 days). 1. 2. Q3. Given the following information, calculate the weighted average cost of capital. Capital structure in millions Equity capital ( Rs.10 par value) 2 14% preference share capital Rs.100 each 1.5 Retained earnings 2 12% Debentures Rs.100 each 4 8% term loan 0.5 Total 10 The market price per equity share is Rs. 45. The company is expected to declare a dividend per share of Rs.5 and dividends are expected to grow at 15% pa. The preference shares are redeemable at Rs. 115 after 5 years and are currently traded at Rs. 90 in the market. Debentures will be redeemed after 5 years at Rs.110. The corporate tax rate is 30%. Calculate the Weighted average cost of capital. Kre/ke=rf + b(er(m) rf = 15% Kp = d/np=1.4/115=1.215% Kd= i(1-t)+((rv-np)/n)/(rv+np)/2 =35(1-0.3)+((100-110)/5)/(100+110)/2 =21.42% Kd term loan=i(1-t)/np=(8(1-0.3)/110 =5.09% The Weighted Average Cost of Capital (WACC) is 5.09%

Q4. Calculate the present value of the following options: a) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa b) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa payable semi annually c) Rs. 5000 to be received every year for 5 years if the prevailing interest rate is 10% pa d) Rs. 5000 to be received after 5 years and Rs. 10,000 to be received after 10 years (a) Present value for receiving Rs.10000 after 5 years at the prevailing interest rate of 10%

The present Value PV =FV{1/(1+i)^n} Where FV =Rs.10000 i = 10% n=5 PV = 10000{1/(1+0.10)^5)} =10000{1/1.61051)} =Rs.6209.21 (b) Present value for receiving Rs.10000 after 5 years at the prevailing interest rate of 10% payable semiannually. The present Value PV = FV{1/(1+i/m)n*m} Where FV = Rs.10000 i = 10% n=5 m=2 PV = 10000{1/(1+0.10/2)^5*2} = 10000{1/(1.62889)} =Rs. 6139.13 (c) The present value to receive to receive Rs. 5000., Every year for 5 years at the prevailing rate of 10% PA is PV = 5000* PVIFA (10%, 5Y) PV = 5000*{1 (1+i)^-5}/i = 5000*{1 (1+0.1)^-5}/0.1 = 5000*(1 0.629092) =Rs.18953.00 (d) (1) Present Value for Rs. 5000 to be received after 5 years if the prevailing rate of interest is 10%pa. Present value PV = FV / (1+ i)^n Where FV = Future value = 5000 i n = 10% =5

PV = 5000/(1+0.1)^5 = 5000/1.61051 = Rs.3105.00 (2) Present Value for Rs. 10000 to be received after 5 years if the prevailing rate of interest is 10%pa. Present value PV = FV / (1+ i)^n Where FV = Future value = 10000 i n = 10% = 10 = 10000/2.59374 = Rs.3855.00 Q5. Explain each of the following: a) Operating cycle b) Shareholders wealth maximisation c) Capital rationing d) Economic order quantity a) Operating cycle: It is the time period involved in the conversion of raw material/resources into finished goods or services including the credit period involved for selling products/services. In simple language. let me give you an extreme example Suppose a business buy raw material on 1st jan and it takes one month to convert this raw material into finished goods. On 1st feb good are ready for sale i.e. stocked at warehouse on 1st march goods are sold and on 1st april payment is received. Now this revenue will be used to buy fresh raw material. The average time it takes for a retailer's or manufacturer's inventory to turn to cash. If a manufacturer turns its inventory six times per year (every two months) and allows customers to pay in 30 days, its operating cycle is approximately three months. Expressed as an indicator (days) of management performance efficiency, the operating cycle is a "twin" of the cash conversion cycle. While the parts are the same - receivables, inventory and payables - in the operating cycle, they are analyzed from the perspective of how well the company is managing these critical operational capital assets, as opposed to their impact on cash. Formula:

PV = 10000/(1+0.1)^10

b) Shareholders wealth maximization: Industrial organization affects the relative effectiveness of the shareholder wealth maximization norm in maximizing total social wealth. In nations where product markets are not strongly competitive, a strong shareholder primacy norm fits less comfortably with national wealth maximization than elsewhere because, where competition is weak, shareholder primacy induces managers to cut production and raise price more than they otherwise would. Where

competition is fierce, managers do not have that option. There is a rough congruence between this inequality of fit and the varying strengths of shareholder primacy norms around the world. In continental Europe, for example, shareholder primacy norms have been weaker than in the United States. Because Europe's fragmented national product markets were historically less competitive than those in the United States, their greater skepticism of the norm's value came closer to fitting the structure of their product markets than did any similar skepticism here. As Europe's markets integrate, making its product markets more competitive, pressure has arisen to strengthen shareholder norms and institutions. c) Capital rationing: Capital rationing is a business decision to limit the amount available to spend on new investments or projects. The practice describes restricting channels of outflow of funds by placing a cap on the number of new projects. Capital rationing may be employed by different kinds of companies to achieve desired financial targets. The theory behind capital rationing practices is that, when fewer new projects are undertaken, the company is better able to manage them through more time and resources dedicated to existing projects and each new project. The placement of restrictions on the quantity of new investments or projects that a company will undertake. Capital rationing is executed through the imposition of a higher cost of capital for investment or the establishment of a ceiling on specific sections of the budget. This decision implies that the costs of raising new capital are prohibitively high with respect to expected returns, creating a situation where capital investment opportunities must compete for funds. Capital rationing may be prompted by past investments that yielded lower returns than expected. This may happen, for example, if a company is involved in too many projects at once leaving most of them too incomplete to yield a substantial profit. In such a case capital rationing may facilitate the maximization of existing projects. d) Economic order quantity: Economic order quantity is the level of inventory that minimizes the total inventory holding costs and ordering costs. It is one of the oldest classical production scheduling models. The framework used to determine this order quantity is also known as Wilson EOQ Model or Wilson Formula. The model was developed by F. W. Harris in 1913, but R. H. Wilson, a consultant who applied it extensively, is given credit for his early in-depth analysis of it. EOQ only applies where the demand for a product is constant over the year and that each new order is delivered in full when the inventory reaches zero. There is a fixed cost charged for each order placed, regardless of the number of units ordered. There is also a holding or storage cost for each unit held in storage (sometimes expressed as a percentage of the purchase cost of the item). We want to determine the optimal number of units of the product to order so that we minimize the total cost associated with the purchase, delivery and storage of the product. The required parameters to the solution are the total demand for the year, the purchase cost for each item, the fixed cost to place the order and the storage cost for each item per year. Note that the number of times an order is placed will also affect the total cost, however, this number can be determined from the other parameters Q6. a) Discuss the advantages of ordering Economic order quantity of inventory. Economic order quantity is the level of inventory that minimizes the total inventory holding costs and ordering costs. It is one of the oldest classical production scheduling models. The framework used to determine this order quantity is also known as Wilson EOQ Model or Wilson Formula. The model was developed by F. W. Harris in 1913, but R. H. Wilson, a consultant who applied it extensively, is given credit for his early in-depth analysis of it. The Economic Order Quantity (EOQ) is the number of units that a company should add to inventory with each order to minimize the total costs of inventorysuch as holding costs, order costs, and shortage costs. The EOQ is used as part of a continuous review inventory system, in which the level of inventory is monitored at all times, and a fixed quantity is ordered each time the inventory level reaches a specific reorder point. The EOQ provides a model for calculating the appropriate reorder point and the optimal reorder quantity to ensure the instantaneous

replenishment of inventory with no shortages. It can be a valuable tool for small business owners who need to make decisions about how much inventory to keep on hand, how many items to order each time, and how often to reorder to incur the lowest possible costs. The EOQ model assumes that demand is constant, and that inventory is depleted at a fixed rate until it reaches zero. At that point, a specific number of items arrive to return the inventory to its beginning level. Since the model assumes instantaneous replenishment, there are no inventory shortages or associated costs. Therefore, the cost of inventory under the EOQ model involves a tradeoff between inventory holding costs (the cost of storage, as well as the cost of tying up capital in inventory rather than investing it or using it for other purposes) and order costs (any fees associated with placing orders, such as delivery charges). Ordering a large amount at one time will increase a small business's holding costs, while making more frequent orders of fewer items will reduce holding costs but increase order costs. The EOQ model finds the quantity that minimizes the sum of these costs. The basic EOQ formula is as follows: TC = PD + HQ/2 + SD/Q where TC is the total inventory cost per year, PD is the inventory purchase cost per year (price P multiplied by demand D in units per year), H is the holding cost, Q is the order quantity, and S is the order cost (in dollars per order). Breaking down the elements of the formula further, the yearly holding cost of inventory is H multiplied by the average number of units in inventory. Since the model assumes that inventory is depleted at a constant rate, the average number of units is equal to Q/2. The total order cost per year is S multiplied by the number of orders per year, which is equal to the annual demand divided by the number of orders, or D/Q. Finally, PD is constant, regardless of the order quantity. Taking these factors into consideration, solving for the optimal order quantity gives a formula of: HQ/2 = SD/Q, or Q = the square root of 2DS/H. The latter formula can be used to find the EOQ. For example, say that a painter uses 10 gallons of paint per day at $5 per gallon, and works 350 days per year. Under this scenario, the painter's annual paint consumption (or demand) is 3,500 gallons. Also assume that the painter incurs holding costs of $3 per gallon per year, and order costs of $15 per order. In this case, the painter's optimal order quantity can be found as follows: EOQ the square root of (2 3,500 15) /3 187 gallons. The number of orders is equal to D/Q, or 3,500 / 187. Thus the painter should order 187 gallons about 19 times per year, or every three weeks or so, in order to minimize his inventory costs. The EOQ will sometimes change as a result of quantity discounts, which are provided by some suppliers as an incentive for customers to place larger orders. For example, a certain supplier may charge $20 per unit on orders of less than 100 units and only $18 per unit on orders over 100 units. To determine whether it makes sense to take advantage of a quantity discount when reordering inventory, a small business owner must compute the EOQ using the formula (Q the square root of 2DS/H), compute the total cost of inventory for the EOQ and for all price break points above it, and then select the order quantity that provides the minimum total cost. For example, say that the painter can order 200 gallons or more for $4.75 per gallon, with all other factors in the computation remaining the same. He must compare the total costs of taking this

approach to the total costs under the EOQ. Using the total cost formula outlined above, the painter would find TC PD HQ/2 SD/Q (5 3,500) (3 187)/2 + (15 3,500)/187 $18,062 for the EOQ. Ordering the higher quantity and receiving the price discount would yield a total cost of (4.75 3,500) (3 200)/2 (15 3,500)/200 $17,187. In other words, the painter can save $875 per year by taking advantage of the price break and making 17.5 orders per year of 200 units each. b) Discuss the Dividend discount model of measuring cost of equity. The Dividend Discount Model is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments. In other words, it is used to evaluate stocks based on the net present value of the future dividends. Dividend discount model is a tool that produces a number based on the data provided. Dividend discount model is a widely accepted financial tool used to evaluate stocks based on the net present value of the future dividends. It works by analyzing and making assumptions related to growth in dividends and interest rates. Its a tool that is heavily based on speculation but what sets it apart from other financial tools is its ability to compare specific numbers based on the given data with accuracy. Dividend discount model can only be applied to stocks that pay dividends. Dividends are portion of earnings that a company decides to give out as cash or stock to its shareholders. Companies that offer dividends, like Microsoft, are usually very stable and secure and have financial strength to continue paying dividends. Dividend discount model can also help investors decide if the future growth in dividends is worth the investment today. The concept of time value of money is crucial in calculations related to dividend discount model. Future growth in dividend payments is discounted to present value of the stock to see if the stock is undervalued or overvalued. Basic dividend discount model formula states that:

There are no two stocks alike so dividend discount model is available both for companies where growth is imminent and companies with no growth. No growth dividend discount model assumes that a company will pay the same amount of dividend until infinity. Constant growth dividend discount model assumes that the company will grow and so the dividends will also grow. No growth dividend discount model dictates the formula:

Where P is the current price, Div is the dividend the company currently pays and r is the discount rate. Formula for constant growth dividend discount model is:

g is the growth rate which is assumed in most cases. Lets say that a company is paying $.60 in dividends and the required rate of return in other securities is equal to 6%. Looking at other growth stocks, assume 2% growth rate.

Using dividend discount model, we just figured out the current price of the stock which is $15. Now lets say that the stock is currently selling for $12, which makes the stock undervalued. If the stock were to be $18, we can assume that it is overvalued. Its a good idea to buy a stock that is undervalued because the amount of future cash flows it is able to generate. Using dividend discount model, it is very easy to identify growth or income stocks that can prove to be profitable if the investment is made in the present. On the other hand, one has to keep in mind that dividend discount model is highly speculative and is based on variety of assumptions. In theory it is one of the best financial tools available to investors but in the real world it is better to use wide range of tools to evaluate stocks.