1. One of the shortcomings of the dividend discount model is that it assumes that the rm can grow at the

same rate indenitely, and projecting a company's future prospects based only on a brief snapshot of its current

status can lead to wildly unrealistic estimates of its growth opportunities. Suppose that shares of Fly By Night

Inc. are currently priced at P0 = 100, compared to a book value of B0 = 20 per share, with forecasted earnings

of E1 = 8 and a scheduled dividend payment of D1 = 3 per share.

(a) Using the constant growth model, estimate Fly By Night's growth rate g and market capitalization

rate r. Do these numbers seem plausible to you?

(b) Upon closer inspection, you observe that all of Fly By Night's growth opportunities consist only of a

single investment project this year. After this year it cannot repeat this or undertake any other positive

NPV project, and must pay out all subsequent earnings to shareholders. Suppose you believe that you

are the only one who is aware of this, while all other investors are convinced that the stock will continue

growing at the same rate forever. What should the stock be priced at?

(c) You now realize that all investors are well aware of Fly By Night's limited growth opportunities, and

that this is already reflected in its price. What is the correct discount rate?