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August 26, 2016 at 2:57 pm #335342Ibrahim
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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 years.What is the current share price of Cant Co using the dividend valuation model?
A $7·35
B $5·57
C $6·11
D $6·28Answer is C
Share price = (0·826 x 0·5)/ (0·1 – 0·03) + (0·25 x 0·826) = $6·11 per share
The present value of the year 2 dividend, discounted at 10%
per year, is (0.25 x 0.826) = $0.2065. I am ok with thisExaminers explation.
The dividends paid in year 3 and subsequently can be valued using the DGM. By using the formula P0 = D1/ (re – g) we can calculate the present value of the future dividend stream beginning with $0.50 per share paid in year 3. This present value will be a year 2 value and will need discounting for two years to make it a year 0 present value.
P0 = (0.826 x 0.5)/ (0.1 – 0.03) = 0.826 x 7.1429 = 5.90. I failed to grasp this bit of the calculation.why the present value will be a year 2 value instead of 3 and why we need discounting for two years to make it a year 0 present. pls i need your helpAugust 26, 2016 at 4:11 pm #335367John MoffatKeymaster Topics: 57
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Using the dividend valuation formula gives the PV now (i.e. the current market value) assuming that the first dividend is in 1 years time and then growing at a constant rate.
Here, the first (growing dividend) is in 3 year time (which is 2 years later than in 1 years time) and therefore the formula gives a value for them 2 years later as well – i.e. at time 2 instead of time 0.
You will know from my free lectures that the MV is always the PV of future dividends, and therefore the value from the formula needs discounting for 2 years to get the current PV (because again, the dividend stream is starting 2 years later than normal – at time 3 instead of time 1).
August 27, 2016 at 5:50 am #335482Ibrahim Topics: 41
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am ok with this statement “the first (growing dividend) is in 3 year time, we discount the value for two years” pls, can u explain more why ‘g’ was included in the denominator (0.1 – 0.03) but was excluded in the numerator. bear with me i just want to know the logic.
August 27, 2016 at 8:07 am #335516John MoffatKeymaster Topics: 57
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In the normal formula the numerator is Do(1+g), which is actually the dividend in 1 years time.
Here you know the dividend in 3 years time and you are now happy with the fact that the result from the formula will be a PV in 2 years time. However because you know the dividend 1 year later (time 3 instead of time 2) you already have “Do(1+g)” and so don’t need to grow it again.
August 27, 2016 at 8:25 am #335519Ibrahim Topics: 41
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ok now I am good to go.Thanks
August 27, 2016 at 8:30 am #335521John MoffatKeymaster Topics: 57
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You are welcome 🙂

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