SSE/EFI Working Paper Series in Business Administration,
Stockholm School of Economics

Abstract: In the abnormal earnings growth (AEG) model of Ohlson and Juettner-Nauroth (2005), there is one interest rate and no taxes. Their model focuses on bottom-line earnings and dividends and is hence viewed as an equity-level model. We first extend this model to a firm-level model based on operating earnings and free cash flows. We then allow for two exogenous interest rates: the required rate of return on equity under all-equity financing and the borrowing rate. A firm-level model is developed where dividends are discounted at the time-varying required rate of return on equity under partial debt financing. Using this firm-level model as a stepping stone, a new equity-level model is developed with dividends discounted at the required rate of return under partial debt financing. Dividend policy irrelevance holds. Finally, the firm-level and equity-level models are extended to a situation with company taxes. Dividend policy irrelevance then no longer holds.

Keywords: Financial analysis; abnormal earnings growth model; dividend policy; discounted dividends; free cash flow

41 pages, First version: December 19, 2008. Revised: March 10, 2009. Earlier revisions: February 25, 2009.

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