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Cant Co has a cost of equity of 10% and has forecast its future dividends as follows:
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 yearsWhat is the current share price of Cant Co using the dividend valuation model?
A $7·35
B $5·57
C $6·11
D $6·28I cannot calculate the present value of the current share price discounted by 10% using DVM.
DVM = ($0.50 x 1.03) / (0.10 – 0.03) = $7.35
Should I apply the 3rd year discount factor to discount the current share price of $7.35 to 3 years discount rate?
PV = $7.35 / (1+10%)^3 = $5.52
Now, this is where I stuck!
PV = $7.35 / (1+10%)^3 + ($0.25 x 0.825) = $5.765
The PV of the year 3 dividend, discounted at 10% per year is ($7.35 x 0.752) = $5.52
The PV of the year 2 dividend, discounted at 10% per year, is ($0.25 x 0.826) = $0.2065.Is that okay?
Why are you attempting a question for which you do not have an answer? You should be using a Revision Kit from one of the ACCA Approved Publishers – they have answers and
explanations 🙂What you have done is fine, except for the fact that your &7.35 is the PV at time 2 and therefore need discounting for 2 year and not for 3 years.
I do work through and explain examples like this in my free lectures. The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
Sir, I got this question while looking into the examiner report and I did watch your lecture on chapter 15. But, I have serious misunderstandings about this question.
This question is answered in the examiner report [March 2016] as follows:
DVM = $0.50 / (0.10 – 0.03) = $7.14
PV = $7.14 / (1+10%)^2 + ($0.25 / 1+10%)^2 = $6.11 [correct answer is C][important questions]
Here market value using DVM has been calculated as $7.14 without taking growth in the dividend to get the dividend for year 4, BUT we have deducted the growth from the cost of equity-like this (0.10 – 0.03). IF we are not taking the growth in the dividend calculation then why are we deducting it from the cost of equity [because it has no relevance]?In my last response, I calculated market value with growth which answers in $7.35 [which u said is correct] and I need to calculate the PV to two years.
Lastly, I have issues with the time of the discount factor. In question, three years time is given where we are at current year time [let say year 0]. So, why do we discounted the PV to year 2 and not year 3 because from Year 0 it is 3 years to be at year 3 [I’m stuck here, your help is needed] 🙁
I am not sure whether we are calculating PV from Year 0 or Year 1.
The numerator in the dividend valuation formula (Do(1+g)) is the same as the dividend in 1 years time.
So if the first dividend was 0.50 in 1 years time (then growing at 3% per year), as opposed to the current dividend being 0.50, then the MV now would be 0.50 / (0.10 – 0.03) = 7.14.
However, the first dividend is not in 1 years time but is two years late and is in 3 years time.
The 7.14 is the PV two years later – i.e. at time 2 instead of time 0.
So the PV ‘now’ is 7.14 discounted for 2 years at 10% which is $5.90.
In addition there is $0.25 in 2 years time, and the PV of this is 0.25 discounted for 2 years at 10% which is $0.21.The total MV is 5.90 + 0.21 = $6.11
Thanks for your answer Sir 🙂 BUT I still have a slight problem with the year’s time!
Since we are in [year 0] & the first dividend will be in [year 2] of $0.25 which is needed to be discount to PV of [year 2]…
BUT in [year 3] dividend of $0.50 is needed to discount to PV of [year 3] NOT [year 2] because this is the dividend in year 3 [confusion why year 2 when discounting as u wrote it is year 2?]
From the view that we are now in [year 0], the dividend of $0.50 is in the [year 3] so we should discount it to the PV of [year 3]. Is not it?
Please state why we need to discount [year 3] dividend of $0.50 to PV of [year 2]? Is there any logical explanation behind this!?
Had the first 0.50 been in 1 years time we would have used the formula to arrive at a PV ‘now’ i.e. at time 0.
Given that the first 0.50 is in 3 years time (which is 2 years later that in 1 years time) the result of using the formula is the PV 2 years later i.e. time 2 instead of time 0.
Therefore we need to discount the answer by 2 years to get the PV at time 0.
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