Exam 2 AM - Why is “assumption 4” least appropriate? Assumption 1: RI is zero beginning in the terminal year Assumption 2: RI is positive and continues at the same level year after year Assumption 3: As return on equity approches the cost of equity, RI tends to 0. Assumption 4: RI growth declines over time and eventually reaches 0. Assumptions 2 and 4 are very close. If RI growth reaches 0 then this means RI will continue forever at the same level - which is Assumption 2. Help, please.
Doesnt 2 say RI is positive. However, I think there are some valuation models which consider that RI would eventually hit 0. To me Assumption 1 looks the least appropriate. why is RI 0 beginnning terminal year ?
Assumption 2 assumes that it’s not at 0. It stays constant at the positive rate.
RI “Growth” doesnt necessary decline over time… RI can and in most cases will decline over time but that doesnt mean the growth rate is declining over time…
Chadtap nailed it. They tricked you. It’s not RI “level” that’s declining, it’s “growth”
Assumption 4 is least appropriate. Same reasoning as Chadtap
this is one of those whimsical word plays (RI ‘growth’) etc. I think there was a DDM question in one of the schweser book 6exams which had an assumption of ‘constant dividend of 4%’ and somehow we were supposed to understand it as 'constant dividend ‘growth’ of 4%. wtf?
I do make the difference between “RI declines” and “RI growth declines” but, sorry guys, I still don’t understand why assumption 4 (RI growth declines over time and eventually reaches 0) doesn’t make sense. If you look at the H-model, this is exactly what is happening. In the H-model, growth is declining (linearly ?) over time (and the long term growth could be 0%). Although I’ve never seen it in exercices or questions, you could apply the H-model to RI… What would be inappropriate. Now if the purpose of the question was to cite our favorite “sauce”, you are right, assumption 4 is not listed as such. But note that assumption 2 with the “RI is positive” is not, neither…
no… Dont compare with the H model… Assuming NI is constant, In most cases RI will decline over time as you will see below. The growth rate however, is not declining. RI is actually less than what it was in the previous year. This would case a negitive growth rate, and an increasing one at that. …yr0…yr1…yr2…yr3 BV…100…120…140…160 NI…20…20…20 E(10%)…10…12…14 RI…10…8…6 Make sense? ROE and R are eventually going to meet (same rate) in the Long Run…