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Nevo Co
Nevo Co has annual sales revenue of $100m and a net operating profit (before interest and tax) of $10m. The company’s operating gearing is 4.5. It has long-term debt of $100m on which it pays fixed interest of 12% per annum. Nevo Co has 150 million $1 ordinary shares in issue. It has never paid a dividend to its ordinary shareholders but it is expected to pay a dividend from next year (in one year from today). Next year’s dividend will be $0.20 and is expected to grow at 5%. Its cost of equity is 12%.
The tax rate applied to the taxable profits of all companies is 20%. The market rate of return is 10% and the risk-free rate of return is 2%.
question is what is the share price?
correct answer is 2.86$…… 0.20/(0.12-0.05)
my answer comes up to 3.00$…
0.20*(1.05)/(0.12-0.05)= 3.00$
i don’t understand why they don’t take the growth rate…
The numerator in the formula is Do(1+g), where Do is the current dividend.
If it is growing at g per year, then Do(1+g) is the dividend in 1 years time.
Here you are told the dividend in 1 years time ($0.20) and so this already includes the growth.
It is quite common in the exam, so check the wording carefully. If you were told that they had just paid 0.20, them you would use 0.20(1.05) in the formula, but if you are told that the dividend will be 0.20 in 1 years time (as in this example) then you do not multiply by 1.05.
Do check my free lectures on this, because the examiner often brings in other complications (such as no dividends for 2 years and then 0.20 in the third year, growing at 5% per year).
The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
thank you for your reply, i understand it now.
Yes, i will go back to the lectures again and go through this part.
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