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Option 1
GG Co could suspend dividends for two years, and then pay dividends of 30 cents per share from the end of the third year, increasing dividends annually by 5% per year in subsequent years. Dividends in recent years have grown by 4% per year
a) Using the dividend valuation model, calculate the value of GG Co under option 1, and advise whether option 1 will be acceptable to shareholders.
The answer they got was:
2.4/(0·10 – 0.05) = $48 million
The dividend valuation model value (the capital value of the dividends at year 0) will be:
48/1·1 2 = $39·65 million
The current present value of dividends to shareholders, using the existing 4% dividend growth rate:
(1.4 x 1.04)/(0.10 – 0.04) = $24·27 million
The proposal will increase shareholder wealth by 39.65 – 24.27 = $15·38 million and so is likely to be
acceptable to shareholders.Please can you explain why in step 2 they divided 48 to 1.12 to get 39.65 and why this method is taken? also why in step 3 they divided by 1.04?
You have not typed out the whole question because you have not stated the cost of equity. I assume that it is 10%.
The dividend valuation formula gives the market value at time 0 when the first dividend is in 1 years time.
Here, the first dividend is in 3 years time, which is 2 years later than in 1 years time. Therefore the answer from the formula is 2 years later i.e. time 2 instead of time 0.
So the answer from the formula needs discounting for 2 years at 10%. You can either use the discount factor from the tables provided, or multiply by 1/(1.1^2)I do explain this, with examples, in my free lectures because it is a common question in the exam. The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
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