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I. The Dividend Discount Model Suppose a stock with price P0 pays dividend D1 one year from now, D2 two years from now, and so on, for the rest of time. P0 is then equal to the discounted value of the future dividends: (1) P=D1 + D2 + D3 +L 0 The discount factor, k, is the firm's cost of equity capital and is given by the CAPM's required rate of return for holding the stock: k=Rf +?(RM ?Rf). k is sometimes called the firm's capitalization rate. II. Some Simplifications and Extensions We can simplify equation (1) by assuming that the company pays the same expected dividend forever. For some companies, this is not a bad approximation. Then: P0=D+ D + D +L 1+k (1+k)2 (1+k)3 P0 is simply a perpetuity with cash payment D and discount rate k. Using the formula for perpetuities:

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