1

Self Study Questions - ANSWERS

TOPIC 3 - VALUATION
PART 2 - EQUITY

Question 1
How much extra would the share price be for two otherwise identical
securities with each having just paid a dividend of $0.20 p.a. per share,
but where one company has positive dividend growth of 2% p.a. The
required rate of return on both shares is 15% p.a.
a) $1.33
b) $0.35
c) $0.23
d) $0.16

Share 1:
No growth in dividends, dividend is constant at $0.20 p.a.
This share is a perpetuity
Use PV of a perpetuity formula to find the price:

33 . 1 $
15 . 0
20 . 0 $
0
= = =
e
r
D
P

Share 2:
Constant growth in dividends of 2% p.a.
Use constant growth in dividends pricing formula to find price:
( ) ( )
57 . 1 $
13 . 0
204 . 0 $
02 . 0 15 . 0
02 . 0 1 20 . 0 $ 1
1 0
0
= =

+
=

+
=
g r
D
g r
g D
P
e e


Therefore, the difference is $1.57 - $1.33 = $0.24

Question 2
The last dividend paid by Buyrite Ltd was $1.00. Buyrites growth rate is
expected to be 5 percent p.a. for 2 years, after which dividends are
expected to grow at a rate of 10 percent p.a. forever. Buyrites required
rate of return on equity is 12 percent. What is the current price of
Buyrites shares?
a) $33.33
b) $42.25
c) $50.16
d) $58.75

Always start from D
0
(i.e. the most recent dividend)
- D
0
= $1.00
- D1 = $1.00 (1+0.05) = $1.05
- D2 = $1.05 (1+0.05) = $1.1025
- D3 = $1.1025 (1+0.10) = $1.2128

To find current price, i.e. P
0
, we must find the PV of D
1
, D
2
, and all the constantly
growing dividends from Year 3 onwards. Remember, dividend growth becomes
constant from Year 3 onwards.
P
0
= PV
0


Step 1: Find P
2
i.e. PV
2
of all the constantly growing dividends one period before
constant growth commences: constant growth commences in Year 3, so using the
2
Question 2 (cont.)
constant growth in dividends pricing formula gives us PV of the constantly
growing dividends at the end of Year 2 i.e. PV
2
or P
2
:

64 . 60 $
02 . 0
2128 . 1 $
10 . 0 12 . 0
2128 . 1 $
3
2
= =

=
g r
D
P
e


Step 2: Next, find PV
0
of D
1
, D
2
, and P
2
using PV of a single sum formula:
PV = FV(1+r)
-n

PV
0
= P
0
= $1.05(1+0.12)
-1
+ $1.1025(1+0.12)
-2
+ $60.64(1+0.12)
-2

= $0.9375 + $0.8789 + $48.34
= $50.16

Question 3
Calculate the dividend yield for Lessitz Ltd, assuming that the required
rate of return is 25% per annum and that the expected growth rate is
17% per annum.
a) 8%
b) 8.5%
c) 6.9%
d) 9%

Dividend yield =
0
.
P
Div

In this example we do not know either Dividend or Price.
However, we know from last weeks lecture that:
r
e
= DY + CGY
where r
e
is required rate of return (on equity)
DY = dividend yield
CGY = capital gains yield
And we also know that where there is constant growth in dividends:
CGY = g
where g = constant growth rate in dividends
Therefore, since we know r
e
= 25% and g = 17% (= CGY) , DY is the
difference between the two, i.e. 25% - 17% = 8%.

Question 4
You are considering acquiring a share and selling it at the end of one
year. You expect to receive both $1.50 in dividends and $26 from the
sale of the share at the end of the year. What is the maximum price you
would pay for the share today if you wanted to earn a 15% return?

a) $23.91
b) $24.11
c) $27.30
d) $27.50

D
1
= $1.50
P
1
= $26
r
e
= DY + CGY
DY = D
1
CGY = P
1
- P
0

P
0
P
0


3
Question 4 (cont.)
Therefore, r
e
= D
1
+ (P
1
P
0
)

P
0


Therefore:
( )
0
0
26 $ 50 . 1 $
15 . 0
P
P +
=

What is P
0
?

( )
( )
0
0
0
0
26 $ 1 50 . 1 $
15 . 0 P
P
P
P
|
|
.
|

\
| +
=

0 0
1 26 $ 50 . 1 $ 15 . 0 P P + =

0 0 0 0
1 1 26 $ 50 . 1 $ 1 15 . 0 P P P P + + = +

50 . 27 $ 15 . 1
0
= P

15 . 1
50 . 27 $
15 . 1
15 . 1
0
=
P


91 . 23 $
0
= P

Alternatively, to get the same answer:

91 . 23 $
15 . 1
50 . 27 $
15 . 0 1
26 $ 50 . 1 $
1
1 1
0
= =
+
+
=
+
+
=
e
r
P D
P

Question 5
Given the following information about Flinstone Ltd., what is the required
rate return of its ordinary shareholders? The expected growth rate of
dividends is 4.5 percent, the current market price of its ordinary shares
is $43.67 and the last dividend paid to the firms ordinary shareholders
was $1.75.
a) 4.5 %
b) 8.00%
c) 8.69%
d) 9.51%

Must use constant growth in dividends price formula to find unknown
required rate of return (r
e
)
g r
D
P
e

=
1
0

P
0
= $43.67
D
0
= $1.75
g = 4.5%
D
1
= $1.8286 (i.e. $1.75(1+0.045))
r
e
= ?
4
Question 5 (cont.)

045 . 0
8286 . 1 $
67 . 43 $

=
e
r

( ) ( ) 045 . 0
045 . 0
8286 . 1 $
045 . 0 67 . 43 $

=
e
e
e
r
r
r
8286 . 1 $ 9652 . 1 $ 67 . 43 $ =
e
r
9652 . 1 $ 8286 . 1 $ 9652 . 1 $ 9652 . 1 $ 67 . 43 $ + = +
e
r
7938 . 3 $ 67 . 43 $ =
e
r

67 . 43 $
7938 . 3 $
67 . 43 $
67 . 43 $
=
e
r

0869 . 0 =
e
r
% 69 . 8 =
e
r

Question 6
Club Auto Parts last dividend, D
0
was $0.50, and the company expects to
experience no growth for the next 2 years. However, Club will grow at an
annual rate of 5% in the third and fourth years, and, beginning with the
fifth year, it should attain a 10% growth rate which it will sustain
thereafter. Club has required rate of return of 12%.
Calculate the value of the stock today.

r
e
= 12%

Step 1: Starting from D
0
, must find dividends in Year 1 through to Year 5
(the first year in which growth in dividends becomes constant)
D
0
= $0.50
D
1
= $0.50 = $0.50
D
2
= $0.50 = $0.50
D
3
= $0.50 (1+0.05) = $0.525
D
4
= $0.525 (1+0.05) = $0.551
D
5
= $0.551 (1+0.10) = $0.606

Step 2: For the constantly growing dividends that commence in Year 5,
find the price/present value in the period before dividends begin to grow
at a constant rate. Dividends grow at a constant rate from t=5 onwards.
Therefore, using the constant growth in dividends pricing formula will
give us P
4
:

30 . 30 $
10 . 0 12 . 0
606 . 0 $
5
4
=

=
g r
D
P
e


Step 3: Find the price today/present value of all the dividends, including
P
4
, using the present value of a single sum formula (PV = FV(1+r)
-n
):

P
0
= D1(1+r)
-1
+ D2(1+r)
-2
+ D3(1+r)
-3
+D4(1+r)
-4
+ P4(1+r)
-4


P
0
= $0.50(1+0.12)
-1
+ $0.50(1+0.12)
-2
+ $0.525(1+0.12)
-3
+$0.551(1+0.12)
-4

+ $30.30(1+0.12)
-4

= $20.83
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Question 7
Mel Hanks has $20,000 to invest in either shares or debentures. The
debentures that Mel is considering have a face value of $1000, an annual
coupon rate of 12 percent and pay interest semi-annually. They are
current selling for $1025 each. An interest payment has just been made
and there are twelve years to maturity.

The shares Mel is considering have just paid a dividend of $1.50 a share,
and are expected to grow at 10 percent for the next five years after
which time they are expected to settle to a normal growth rate of 4
percent. The current market price of the shares is $25.50.

(a) If Mel determines the appropriate required rate of return for the
shares to be 13 percent and the current market interest rate for
the debentures to be 10 percent, determine the value of each
investment.
(b) Advise Mel which securities, if any, he should invest in?

Answer

(a) Debentures

Face value = $1,000
Coupon rate = 12% p.a.
Coupon PMT = 12% of $1,000 = $120/2 coupon payments per year = $60
n = 12 years to maturity x 2 coupon payments per year = 24
r = current market interest rate = 10% p.a./2 coupon payments per year = 5%

Use Bondpricing formula to find the correct price of the bond:

00 . 138 , 1
) 05 . 0 1 (
1000
) 05 . 0 (
) 05 . 0 1 ( 1
60
24
24
0
=
+
+
(

+
=

P


6
Question 8 (cont.)

Shares

Step 1: Starting from D
0
, must find dividends in Year 1 through to Year 6
(the first year in which growth in dividends becomes constant)


( )( )
( )( )
( )( )
( )( )
( )( )
( )( ) 5124 . 2 04 . 1 4158 . 2
4158 . 2 1 . 1 1962 . 2
1962 . 2 1 . 1 9965 . 1
9965 . 1 1 . 1 815 . 1
815 . 1 1 . 1 65 . 1
65 . 1 1 . 1 50 . 1
$1.50 D
6
5
4
3
2
1
0
= =
= =
= =
= =
= =
= =
=
D
D
D
D
D
D


Step 2: For the constantly growing dividends that commence in Year 6,
find the price/present value in the period before dividends begin to grow
at a constant rate. Dividends grow at a constant rate from T
6
onwards.
Therefore, using the constant growth in dividends pricing formula will
give us P
5
:

92 . 27 $
04 . 0 13 . 0
5124 . 2 $
6
5
=

=
g r
D
P
e


Step 3: Find the price today/present value of all the dividends, including
P
5
, using the present value of a single sum formula (PV = FV(1+r)
-n
):

P
0
= $1.65(1+0.13)
-1
+ $1.815(1+0.13)
-2
+ $1.9965(1+0.13)
-3
+
$2.1962(1+0.13)
-4
+ $2.4158(1+0.13)
-5
+ $27.92(1+0.13)
-5

= $22.07

(b) The debentures are underpriced (market price < intrinsic value), whereas
the shares are overpriced (market price > intrinsic value). Hence, Mel
should invest in the debentures.