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Could you please explain detail on below question?
A company has just paid a dividend of .23 per share, shareholders expect that dividend to remain .23 per share for next year but to increase at 3% thereafter, shareholder req. rate of return is 12% . TaX is 25% find out current market value.
We use the dividend valuation formula from the formula sheet.
The top of the formula (which is written Do(1+g)) is actually the dividend in 1 years time, which here is 23c.
g = 0.03
Re = 0.12
Tax is not relevant at all.If you put these figures in the formula you arrive at a market value of $2.56
Hi John,
I had wanted to ask exactly the same question. Really sorry but I must be having a brain freeze as I still can’t get it. If we can use the expected div in one year’s time then I keep coming up with:
MV = ($0.23 x 1.03)/(0.12-0.03) = $2.63
I must be missing something but can’t figure out what??
Also, the other MCQ I couldn’t figure out:
Current share price $4. Rights issue 1 for 5 at issue price $3.10.
Question – what is the theoretical value of rights (per existing share)?I worked out the TERP to be $3.25 and therefore the value of the rights to be $0.15 but, since the question asked for the value per existing share wouldn’t this be $0.03. The answer given is $0.15.
My notes say, when asked to calculate ‘value per existing share’ you have to divide the value by the number of shares needed (ie 5). I must be misunderstanding something but not sure what?
Many thanks,
Jenny
Sorry, John. Ignore the second part – I was having a senior moment and had calculated the TERP incorrectly, numpty.
Just the first part I still don’t get!
The MV = 0.23/(0.12-0.03).
The dividend in one years time is 23c per the question. It is not the current dividend multiplied by (1+g) – usually it is, but not in this question.
Dear John,
The explanation given above is not consistent with the dividend growth model in my opinion. Po = Do(1+g)/re-g. Using 0.23 indeed appreciates that there wont be any growth for a year. g=0 for 1 year. According to the formula, g is the same in the formula and can’t therefore represent different variables in the same working. i.e 0 in the numerator and 0.03 in the denominator. I guess the question has a problem. Please help.
You are wrong – it is completely consistent!
There is nothing wrong with the question and it is exactly as the examiner himself has asked it on several occasions.
He is checking that you understand that the market value of shares in the present value of future expected dividends (even though we usually use the formula as the way of arriving at the present value of a growing perpetuity).
In the formula, Do(1+g) represents the dividend in 1 years time. The formula would be better written as D1 / (Re – g), where D1 is the dividend in 1 years time (and many books do write it this way). The examiner chooses to write it as Do(1+g)/(Re-g) which may seem confusing (and may perhaps be unfair), but it is only correct written that way if the dividend starts growing immediately.
More and more often the examiner has had questions where the dividend does not start growing until a later year – again, to test that you understand and are not simply using a formula without understanding.
(If you are not convinced, then you will have to prove the formula and you will see that I cam correct – it doesn’t take long (but it does involve iteration). However, I think you would be better taking my word for it than wasting time 🙂 )
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