One of the assumptions of the two-stage growth model is that the dividends drop immediately from the high growth rate to the perpetual growth rate. What do you think about this assumption?

Two stage growth | Business & Finance homework help

The two-stage growth model is a useful way to estimate the value of a company by taking into account its current and projected future performance. Specifically, it assumes that after an initial period of high growth (Stage 1), dividends will drop immediately from this high rate to the perpetual growth rate (Stage 2). This assumption can lead to inaccurate valuations if the market conditions are different than those assumed in the model.

For example, if there is potential for further accelerated growth after Stage 1, then using only a perpetual growth rate during Stage 2 would fail to capture this additional future revenue stream. Additionally, investors may be unwilling or unable to pay for long-term investments based on just Stage 1’s higher expected returns due to factors such as risk aversion and liquidity constraints. As such, leaving out any consideration of these circumstances could result in overestimation of values derived from the two-stage model due to ignoring any benefit associated with sustained higher returns beyond Stage 1.

Moreover, setting dividend levels at either stage without properly factoring in other inputs like share dilution caused by issuing new shares or reinvestment assumptions could also introduce inaccuracies into valuation estimates produced through use of the two-stage model. Therefore, although this approach has been found useful under certain conditions where markets behave predictably over time and no unusual events occur that might disrupt earnings expectations, it should be considered carefully before applying blindly given its limitations which can provide misleading results when applied in situations outside of its intended scope.