The last dividend of company ABC was £6. Dividends of company ABC are now growin

Question

The last dividend of company ABC was £6. Dividends of company ABC are now growing at a rate of 20 per cent per annum. The required rate of return for companies with comparable risk is 10 per cent per annum. It is assumed that the period of fast growth will last for 4 years. After that the company will grow at a normal rate of 8 per cent per annum.

Required:

i) Calculate the present value of the ABC share.

ii) Assume that after the period of the first five years (four years of fast growth and one year of normal growth) the situation in the sector suddenly changes due to high competition. If the company will pay a constant dividend at the level of year 5 from then on, calculate the share price of the company. Compare the results in parts (a) and (b) and comment on them.

Explanation / Answer

D0 £       6.00 D1 £       7.20 20% D2 £       8.64 20% D3 £    10.37 20% D4 £    12.44 20% D5 £    13.44 8% P4 = D5/Ke-g 13.44/(.10-.08) £        672 Prseent vlue of ABC share = cash flows received in all 4 years discounted at 10% rate PV = 7.20/1.1 + 8.64/1.1^2 + 10.37/1.1^3 + (12.44+672)/1.1^4 £ 488.96 Part b D0 £       6.00 D1 £       7.20 20% D2 £       8.64 20% D3 £    10.37 20% D4 £    12.44 20% D5 £    13.44 8% D6 £    13.44 P5 = D6/Ke Since after 5th year there is no growth in dividend 13.44/.1 £ 134.40 PV = 7.20/1.1 + 8.64/1.1^2 + 10.37/1.1^3 + 12.44/1.1^4 + (13.44+134.40)/1.1^5 £ 121.77 If there is no growth in dividend, price of share signifcantly lower than price of growth in dividend.

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