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Sir, can you please explain that Chap 15 (Valuation of Equity) example 3 & 4 are both the same
For example 3 you have used the formula to calculate the Market value of a share such as:
MV = 20c / 10% = $2But For example 4 you have used Perpetuity because the dividend stream remains constant in the future years (but it was also the case in example 3 but you didn’t use the perpetuity for that)
Perpetuity formula = 15c x 1/12% = $1.25
In your lecture, you said that “The market value of a share is the present value of future expected dividends, discounted at the shareholder’s required rate of return” which I completely understand.
Both the formula & perpetuity approach result in the same answer so I wanted to know that when the dividend remains constant for the future years, then we can either use the formula or Perpetuity approach to calculate the market value of a share. Is that correct?
I think you are referring to examples 1 and 2 (not 3 and 4).
I am using example 1 simply to explain why it is that the MV of a share depends on the future expected dividends and the shareholder required rate of return.
In example 2 I am explaining that because of that, the MV is always the present value of the future expected dividends discounted at the shareholders required rate of return. And as you should remember from Paper MA (was F2) the discount factor for a perpetuity is 1/r when r is the discount rate.
I do this because only 50% of the exam involves calculations and the rest of the exam is testing that you understand what is happening and have not simply just learned rules.
As you will see from the later examples in the chapter, questions in the exam are rarely such basic questions and in more complicated ones there is growth in the future expected dividends and we use the growth formula that is given in the exam, or there are individual dividends for a few years following by constant growth in later years, in which case we have to discount the individual dividends in the normal way and apply the growth formula to the later dividends.
My apologies, I have given you examples 1 & 4 in my previous question although I was referring to examples 3 & 4.
For example 3 you have used the formula to calculate the Market value of a share such as:
MV = 15c / 12% = $1.25 (ex-div)But For example 4 you have used Perpetuity because the dividend stream remains constant in the future years (but it was also the case in example 3 but you didn’t use the perpetuity for that):
Perpetuity formula = 15c x 1/12% = $1.25
My question is that since both ways the formula & perpetuity approach result in the same answer of $1.25 (ex-div) so it doesn’t matter which one to use and we can either use the formula (MV = Div / r) or Perpetuity approach (1/r) to calculate the market value of a share. It won’t change our answer because they both pretty much work the same way.
In both of the ways, it is assumed that the dividend stream will continue in the future in perpetuity.
Is there anything wrong what I said? Thanks for your last reply, it was helpful. 🙂
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