Question 4 June 2013 — OpenTuition Forums

DDinh9y ago

Dear Sir, In this question: 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. In the answer: capital value at the end of the second year will be: 2·5/(0·09 – 0·04) = $50 million My question: GXG suspend dividends for 2 years. Why do we calculate value at end of the second year with 4% dividend increase as above? Thanks, DT

John MoffatTutor9y ago#1

The market value, as always, is the PV of the future expected dividends. We use Gordons growth model to get the PV and hence the MV), but that gives a current MV on the assumption that the first dividend is in 1 years time. If the first dividend is later, then we need to discount the result to get the MV now. The numerator in the formula ( Do (1+g) ) is the dividend in 1 years time and the formula then gives the MV now. Here, you are given the dividend in 3 years time (which is 2 years later than in 1 years time), so using that dividend gives a MV in 2 years time, which then needs discounting for 2 years to get the MV 'now'.

DDinh9y ago#2

Thanks John

John MoffatTutor9y ago#3

You are welcome :-)