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CORHIG CO (JUNE 2012 MODIFIED)
Corhig Co is a company that is listed on a major stock exchange. The company has struggled to maintain profitability in the last two years due to poor economic conditions in its home country and as a consequence it has decided not to pay a dividend in the current year.However, there are now clear signs of economic recovery and Corhig Co is optimistic that payment of dividends can be resumed in the future. Forecast financial information relatin to the company is as follows:
Year 1 2 3
Earnings ($000) 3,000 3,600 4,300
Dividends ($000) nil 500 1,000
The company is optimistic that earnings and dividends will increase after Year 3 at a
constant annual rate of 3% per year.Corhig Co currently has an equity beta of 1.6. The risk?free rate of return is 4% per year and the equity risk premium is 5% per year. The current average price/earnings ratio of listed companies similar to Corhig Co is 5 times.(b) Calculate the current cost of equity of Corhig Co and, using this value, calculate the
value of the company using the dividend valuation model. (6 marks)Years 2 and 3.
PV of year 2 dividend = 500,000/1.122 = $398,597
PV of year 3 dividend = 1,000,000/1.123 = $711,780
Year 3 PV of dividends after year 3 = (1,000,000 × 1.03)/(0.12 – 0.03) = $11,444,444
Year 0 PV of these dividends = 11,444,444/1.123 = $8,145,929sir, how is this present value calculated in this part ?
The cost of equity is 12%
The MV is the PV of future dividends discounted at 12%.
So the year 2 and year 3 dividends should be no problem – simply discount for 2 years and for 3 years at 12%.
With regard to the dividends after year 3, since there is constant growth we use the dividends growth formula from the formula sheet.
However, this gives a PV ‘now’ assuming that the first dividend is in 1 year. However here the first dividend is in 4 years, which is 3 years later. Therefore the formula gives a PV 3 years later – at time 3 instead of time 0 – and therefore needs discounting for 3 years at 12%.(It is somewhat quicker to use the discount factors at 12% rather than use first principles as you have typed. And I assume that you meant to type 1.12^2 and 1.12^3, and not 1.122 and 1.123)
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