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Dear sir, could you please help me with the solution to this problem:
June 2013 Q4 (a), thank you very much in advance!!GXG Co is an e-business which designs and sells computer applications (apps) for mobile phones. The company needs to raise $3,200,000 for research and development and is considering three financing options.
Option 1
GXG Co could suspend dividends for two years, and then pay dividends of 25 cents per share from the end of the third year, increasing dividends annually by 4% per year in subsequent years. Dividends in recent years have grown by 3% per year.GXG Co has a cost of equity of 9% per year, which is expected to remain constant.
(a) Using the dividend valuation model, calculate the value of GXG Co under option 1.
In the ACCA answer, it says
If these dividends increase by 4% per year in subsequent years, their capital value at the end of the second year will be:2·5/(0·09 – 0·04) = $50 million
The dividend valuation model value (the capital value of the dividends at year 0) will be: 50/1·09^2 = $42·1 million
The current present value of dividends to shareholders, using the existing 3% dividend growth rate:
(1·6 x 1·03)/(0·09 – 0·03) = $27·5 million
I have two questions about this,
first, when calculating the capital value of the dividends, why doesn’t use the formula? I thought it should be 2.5(1.04)/(9%-4%).
Second, the answer says that it is the capital value in two years time, but in the question “25 cents per share from the end of the third year”, so I don’t understand why it’s not M.V. in three years.
?
Thanks again for your time and patience! (I’m so sorry if I’ve put this in a bad way, English is not my first language:(They have used the formula 🙂
Normally, we are given the dividend that has just been paid. This is Do.
on the top of the formula we put Do(1+g) – this is the current dividend plus a years inflation and so is the dividend in 1 years time. The formula then gives the PV now.In this question you are told the dividend in 3 years time, and so if we put that on the top of the formula, it is 2 years later than usual (i.e. in 3 years time instead of in 1 years time).
so the answer from the formula will be the MV in two years time (again 2 years later, so time 2 instead of time 0).The examiner has questions like this a lot, and I do explain in my free lectures (the lectures are a complete free course and cover everything needed to be able to pass the exam well.)
Now I get it. Thank you so much sir. My best teacher! I will definitely review your wonderful lectures.
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