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Hello John, this is MCQ 225 from the BPP (Sep ’19 to Jun ’20) kit.
Cost of equity 10%
Current year- no dividend
Year 1- no dividend
Year 2- $0.25 per share
Year 3- $0.50 per share and increasing by 3% per year in subsequent yearsSolution from the kit:
(0.826 x 0.5)/(0.1-0.03) + (0.25 x 0.826) = $6.11 per share.My solution, using open tuition notes as a guide:
(0.5 x 1.03)/(0.1-0.03) x 0.826 + (0.25 x 0.826) = $6.28 per shareWhat have I done wrong and why am I wrong?
You should not have multiplied the 0.5 by 1.03 in the first term in your equation. Then you would have arrived at the correct answer of $6.11 per share.
The reason is that had the first of the growing dividends been in 1 years time, the formula would have given the PV ‘now’. The term Do(1+g) is the current dividend plus 1 years growth and is therefore the dividend in 1 years time.
Here, the first growing dividend is at time 3 instead of at time 1, and therefore the formula gives the PV two years later i.e. at time 2 (and so needs then to be discounted for 2 years). The term Do(1+g) is the dividend at time 3 instead of at time 1 and is therefore $0.50 (not $0.50 plus growth).
You say that you have used our notes as a guide, but did you watch the free lectures that go with the notes (because I do explain this in the lectures). It is pointless to use the notes without watching the lectures – they are only lecture notes and it is in the lectures that I explain and expand on the notes.
Yes, I watched the videos with the notes.
I am talking about Chapter 15, page 78, example 7 of the notes.
They calculated p2 as 20c(1.04)÷ 0.15-0.04 then, multiplied by 0.756.
But with the BPP MCQ, they didn’t multiply the dividend by the growth rate first. Please John kindly explain.
The alternative way is to do what you were doing.
However using (0.5 x 1.03)/(0.1-0.03) would give the value in 3 years time of the dividends from time 4 onwards (because it is using the dividend at time 3 as being Do).
So the answer would then need discounting for 3 years to get the PV (not 2 years).Having got the PV of the dividend from time 4 onwards, you then need to add on the PV of the dividend in 2 years time (which you have done correctly) and also add on the PV of the dividend of 0.50 in 3 years time.
If you do that you will again end up with the same answer 🙂
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