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Mr Moffat,
When calculating the capital value at the end of the second year, I don’t understand why the 4% growth is deducted from the 9% cost of capital. My understanding is that the 4% is the growth in year 4 and subsequent years. If we do not pay a dividend in year 2, then why do we use the 4%?
Thank you for your help.
Catherine
If the growth in dividends was starting immediately then we would simply use the formula (with 9% cost of equity (not cost of capital) and 4% growth). On the top of the formula we would have Do(1+g) which is the same as the dividend in 1 years time, and the formula would give us a market value now.
In this question, everything is exactly the same except for the fact that the first dividend is in 3 years time instead of in 1 years time – i.e. 2 years later than usual.
So using the formula in the normal way will give us a market value 2 years later – i.e. in 2 years time instead of now. So we then need to discount the answer by 2 years.
Sir john how can we use the formula in a normal way specially when the growth will happen 2 years later , so for DVM we need a pattern of growth and in those 2 years there is no dividend let alone a pattern , the pattern can only be established in the 4th year
And furthermore the formula itself is quite confusing how come growth has not been added in numerator to the value of dividend but subtracted in the denominator?
i have the same doubt. Why have they subtracted the dividend growth % directly from the CoEq.?
Ohh now i understood the question. The confusion was because the BPP book gives another formula for DVM which is different from DGM.
and here they have done the sum using the DGM and called it as DVM, which basically means the same thing 🙂 *sighs*
Muslim Farooque:
The numerator is the dividend in one years time. Usually we know the time at time 0 and therefore the dividend in 1 years time is Do(1+g).
However, if instead we know the dividend in 1 years time then we use this as the numerator.When we have the dividend in 1 years time as the numerator (either as Do(1+g) or directly as D1) then the formula gives the present value at time 0 which is the current market value.
In this question we know the dividend in 3 years time (which is 2 years later than D1) and therefore the formula gives a market value 2 years later – i.e. at time 2. So the answer then needs discounting for 2 more years to get the current market value.
Our free lectures will help you. Our lectures are a complete course for Paper F9 and cover everything needed to be able to pass the exam well.
Hi,
In this question, the examiner finds the share price in year 2.
Since the growth is starting from year 4 onwards, can we work out year 3 PV as 25c/1.09^3 and then we use the DGM from year 4 onwards, hence finding the value of the shares in year 3? 25c x 1.04/ (0.09 – 0.04). Then we divide the answe by 1.09^3 as that would the value of the shares in year 3.
The answer will be the same. Hence, like this, there will be consistency with the question of June 2012 Qs 4 which is very similar.
Thanks
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The working would still be correct even though it is not as past paper answer?
Mich
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