St James’ Ltd. Has just paid a dividend of £0.22 per share. The market expects

Question

St James’ Ltd. Has just paid a dividend of £0.22 per share. The market expects this dividend to grow constantly in each future year at the rate of 7% p.a. The cost of capital for St James’ Ltd. is currently 9%. As soon as the dividend was paid, however, the Board of St James’ Ltd. decided to finance a new project by retaining the next three annual dividend payments. The project is seen by the market to be of riskier than existing projects and the cost of capital is estimated to be 10%. It is expected that the dividend declared at the end of the fourth year from now will be £0.30 per share and will grow at the rate of 8% p.a. from then on.

You hold 1,000 shares in St James’ Ltd. and your personal circumstances require that you receive at least £200 each year from this investment.


(i) Assuming that there is a perfect market in St James’ Ltd's shares, and that the market uses a dividend valuation model, show how the market value of the shares has been affected by the Board's decision.

Explanation / Answer

Here we have D0=0.22, 1000 Shares

Case A: When g=7%, Ks=9%, Do=0.22
So Share price will be P0 = D0*(1+g)/(Ks-g) = 0.22*(1+7%)/(9%-7%) = $11.77


Case B : When g=8%, Ks=10%, Do=0.22, D1=D2=D3=0, D4=0.30
SO Price at end of Y4 = P4 = D4*(1+g)/(Ks-g) = 0.30*(1+8%)/(10%-8%) = $16.20
Now lets calculate the PV of this P4 at P0

P0 = D0+D1+D2+D3+PV of Horizon value P4
ie P0 = 0.22 +0+0+0+16.20/(1+10%)^4 = $11.28

By seeing the P0 of Case A & Case B, we see that the Mkt price of Share has comedown from $11.77 to $11.28 due to Boars's decision.

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