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The Application of the DCF Methodology for Determining the Cost of Equity Capital

Jeremy J. Siegel
Financial Management
Vol. 14, No. 1 (Spring, 1985), pp. 46-53
Published by: Wiley on behalf of the Financial Management Association International
Stable URL: http://www.jstor.org/stable/3665360
Page Count: 8
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Since scans are not currently available to screen readers, please contact JSTOR User Support for access. We'll provide a PDF copy for your screen reader.
The Application of the DCF Methodology for Determining the Cost of Equity Capital
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Abstract

The proper use of the simple DCF formula requires that firms change their dividend levels quarterly and that the price of the stock be chosen on the ex-dividend date. This paper derives simple approximations that can be used when the above conditions do not apply. It is shown that failure to correct DCF calculations for firms that change dividends annually rather than quarterly results in a 1.7% overestimate of the true yield when the price of a stock is chosen early in the dividend year and a like underestimate when the price is chosen late in the year. Ignoring the accrued dividend between ex-dividend dates results in an underestimate of the required return by up to 3%. Furthermore, it is shown that the use of averaging periods to compute the price of a stock results in a very slight underestimate of the true return for a six-month averaging period, but a 1.4% underestimate for a one-year period.

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