Business Valuation J13 Q4 (a)

Usually we simply use the dividend growth formula and get the market value immediately.

However, the formula gives the market value now, when we know the current dividend and where that dividend is growing and being paid in 1 year from now, 2 years from now, and so on. The formula also assumes that the current dividend has just been paid.

The problem here is that there are no dividends for the next 2 years, and it only starts in 3 years time.

So although we can use the formula, because the dividends start in three years time, we use 25c as the “current dividend” and the answer from the formula will give the market value in 3 years time. Also, it will give an ex div value which means that it will not include the 25c that is payable in three years, so we need to add that to the value.

Finally, because the answer is now a value in three years time, to get a value now we need to discount for 3 years at the shareholders required rate of return (which is equal to the cost of equity).

(Remember that although we usually just use the formula, that the market value is always the present value of the future expected dividends, discounted at the shareholders required rate of return – this is actually where the formula itself comes from)

You are welcome 🙂

1) You are asked to calculate the value under option 1 – i.e. the value if they withhold dividends and then get growth of 4%.
You are also asked whether this would be acceptable. To do this you need to know what the current value is – if option 1 makes it higher then it is acceptable, if it makes it lower then it is not acceptable.

2) The examiners answer is correct.
There are two ways of getting the same answer.
The way he has done it has calculated the MV at time 2 and then discounted for 2 years. The reason that there is no (1+g) on the top of the formula, is that the normal Do(1+g) represents the dividend in 1 years time. If we put ourselves at time 2, then dividend in 1 years time will be the dividend at time 3, which is 25c (not 25c + growth).
The formula gives an ex div value always and that is correct here.

Alternatively you can use the formula to calculate an ex div value at time 3. In this case the dividend one year later will be 25(1.04). However because there is a dividend at time 3 also, this will need adding on to the ex div value given by the formula.
The resulting figure then needs discounting for 3 years because it is a value in 3 years time.

Both approaches will give exactly the same answer, and both would get full marks.

Dear Mr. Moffat, Thank you for your incredibly quick reply! Sorry I posted another comment before reading your reply, but I think I understand now. This question has been bothering me for the longest time. Thank you for all of your lectures!

could you possibly explain how the discounting is done? is there another way this could have been done as i don’t understand the method in the answer?

Thank you

Jemma