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CFA Level I · CFA Level I Exam · Discounted Cash Flow (DCF) and Growth Models

In a two-stage dividend discount model with a high-growth period of n years followed by constant growth, the terminal value at the end of year n is most likely estimated as:

The terminal value at the end of year n equals the year n+1 dividend divided by the required return minus the stable growth rate. This is the Gordon growth formula applied when growth becomes constant, so the high growth rate is no longer relevant after the high-growth period.

  1. AThe year n dividend divided by the required return
  2. BThe year n+1 dividend divided by the required return less the high growth rate
  3. CThe year n+1 dividend divided by the required return less the stable growth rateCorrect

Explanation

At the end of year n the stock is valued with the Gordon growth model, which uses the next dividend (year n+1) and the stable growth rate that applies from then on. The high growth rate no longer applies after year n. Using the year n dividend or the high growth rate gives a wrong terminal value.

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