Chapter 9 - Q9.1

Discussion in 'SA7' started by DamienW, Sep 7, 2019.

  1. DamienW

    DamienW Made first post

    Hi Colin,
    The solution shows a formula d=r + ERP + g(real div growth)
    Can you please explain how this formula is derived?

    CA1 has a similar formula d+g=r+inflation+ERP hence d=r+ERP-g
    I think g here refers to capital growth but not dividend growth.
    Can you please explain the difference between capital growth and dividend growth? Is there a formula showing the relation between them?

  2. Colin McKee

    Colin McKee ActEd Tutor Staff Member

    Hi, Hmmm - there appears to be a typo in the notes! I dont know how that survived this long without being commented on. The formula in the 9.1 solution should say d = r + ERP - g(real).
    Once this adjustment is made, the two formulae you mention above are the same. Your CA1 formula is d + g = r + infl + ERP where g is the expected capital gains. CA1 (CP1 now) also states that over the long term, there is no reason why a share should grow in capital terms at a rate that is different from its dividend growth rate. ie, dividend up 5% = share price up 5%. The reasoning behind this is, I think, that if dividend yield remain the same over time, or are mean reverting, then Price = Dividend / Yield (where Yield would be a constant). There is a good argument for assuming that Yield will be mean reverting over time I think. This assumption works over VERY long period, but clearly is not accurate over any shorter period.
    If we believe this, and we break dividend growth into the part that comes every year from inflation, and the "real" component that the company achieves through productivity gains and effeciencies, then g can become g*+inflation, where g* is "real" dividend growth. After that, inflation cancels both sides and you end up with d + g* = r + ERP which is your first formula (after correcting the typo).

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