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Dear tutor,
Now, regarding the F9 paper, June 2013 ,question 4 part (a) is very difficult for me. The examiner is using the dividend valuation model to discount the present value of the dividends for year 3 to year 2 (as the model takes us to present values one year behind). I understand this but the problem is when he is doing this he just does 2·5/(0·09 – 0·04) = $50 million. However, the valuation model formula (the numerator is supposed to be) Do(1+g) so I understand that the dividends right now are 1600 so why has he taken 2.5? Also, even if he takes 2.5 then why is this 2.5 not inflated up to reflect the growth of 4% in subsequent years. Why is the numerator not 2.5*1.04^3? Please explain this crucial and very difficult issue to me.
Finally, in OT suggested answers for question 4 (c) the answers say that interest cover ratio falls substantially and therefore increases risk for shareholders while the examiner in his answer writes that the interest cover is yet “healthy” and “acceptable” and wouldn’t bother shareholders much so which is the correct perspective. Please clarify this.
Thanks.
Although the current dividend is 1600, but under option 1 the dividend will be 25c per share which will be 2.5M in total (and it is option 1 that you are asked to consider).
With regard to the formula, is we are wanting the market value now, we use Do(1+g) as the numerator. Do(1+g) is the dividend in 1 years time.
Here, he has used the formula to calculate the market value in 2 years time, and so the dividend 1 year later is 2.5M (not 2.5M x (1+g))
He has then discounted by 2 years to get back to a market value now.My statement about the interest cover does not conflict with that of the examiners. It has fallen substantially and a fall in interest cover does increase risk to shareholders. At the same time however, the examiner is correct in saying that it has not fallen to a dangerous level.
Do appreciate that the written parts are not marked word for word with the examiners suggested solution – the marks are for proving that you understand what you are writing about.
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Sir can you explain in option a why did he divide the market value at year 3 by (1.09^2)
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