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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,
DTThe 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’.
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