Paper 2 September 2014 Q6

[Frances]

For the part of the question describe how investment trust might value its unquoted investments using cashflow techniques -

I don't understand the part of the solution where it talks about the discount rate. It seems to say that the dividends could be discounted at an appropriate rate based on long term conventional gov bonds + adjust for default risk + adjust for marketability/liquidity. (This part I am okay with).

It then goes on to say: the yield on an index linked government bond could be used in the discount rate, along with the real (rather than nominal) rate of dividend growth. - Is this instead of the approach outlined above? Also, why would you take the real rather than nominal rate of dividend growth/why would you take the dividend growth full stop?

Thanks,

Fran

 

[Lindsay Smitherman]

Hi Fran

This relates to the dividend discount model which is covered in Section 3.2 of Chapter 23. It simplifies to D/(i-g) where D is the dividend payable in one year's time, i is the required rate of return (the discount rate) and g is the assumed dividend growth rate.

Under this approach, you can either use nominal i and nominal g or real i (e.g. yield on index-linked government bond) and real g. (This is mentioned in Section 3.3 of that Chapter).

Hope that clears this up for you.

 

[Ana Chew]

Hi Fran

This relates to the dividend discount model which is covered in Section 3.2 of Chapter 23. It simplifies to D/(i-g) where D is the dividend payable in one year's time, i is the required rate of return (the discount rate) and g is the assumed dividend growth rate.

Under this approach, you can either use nominal i and nominal g or real i (e.g. yield on index-linked government bond) and real g. (This is mentioned in Section 3.3 of that Chapter).

Hope that clears this up for you.

Do both methods arrive at the same denominator?

 

[Lindsay Smitherman]

Yes, broadly speaking they would, since nominal = real + inflation (although in practice it would depend on the sources used for the various rates, as they may include slightly different inflation estimates).