Question

1. Your company expects to pay a dividend of $1 per share, $2.4 per share and $3 per share over the next 3years. Thereafter, dividends are expected to grow at 15 % per annum from 2 years, then 10% definitely. If your cost of capital is 24%, what price will investors be willing to pay for a share of the stock today

2. The company has paid a dividend of $300 per share, which is expected to grow at 15% per annum. Investors required return is 30%. What is the expected market value?

3. The Government is in the process of issuing a 6-year bond which has a coupon rate of 15%. The face value is $10,000 per bond. The government pays interest, annually. You are the Finance Director of ABC Ltd a medium-sized company which is interested in buying the bond issued by the

Government. The company’s cost of capital is 20% p.a.

1. Advice the company on how much should be paid for the bond.

If the bonds were issued by a private company, would you be prepared to pay the same amount as in (a). Justify your position

Answer 1

(a) D1 = 1 ; D2 = 2.4 ; D3 = 3 ; D4 = 3.45 (15% growth rate); D5 = 3.9675 (15% growth rate) ; D6 = 4.36425 and thereafter grow @10% (growth rate ) indefinately

Cost of capital (r)= 24%

Price of stock today = D1/(1+r%) + D2/(1+r%)2 + D3/(1+r%)3 + D4/(1+r%)4 +D5/(1+r%)5 + D6/r%-g% * 1/(1+r%)5

1/(1+24%) + 2.4/(1+24%)2 + 3/(1+24%)3 + 3.45/(1+24%)4 +3.9675/(1+24%)5 + 4.36425/24%-10% * 1/(1+24%)5

= 0.8065 + 1.56096 + 1.5735 + 1.45935 + 1.3533 + 10.6331 = $ 17.38671

(b) Dividend paid = 300 ; growth rate = 15% ; required return of investor (r) = 30%

Price of stock = Dividend paid (1+growth rate) / r-g = 300(1+15%) / 30%-15% = $ 2,300

(c) 6 year bond ; coupon rate = 15% ; face value = $ 10,000 ; Interest is paid anually ; cost of capital (r) = 20% p.a.

Coupon amount = 1500

Price of the bond = coupon amount * PVAF ( 20%, 6 years) + Maturity Value * PVF ( 20%, 6th year)

= 1,500 * (3.3255) + 10,000 * (0.3349) = $ 8,337.25 can be paid for the bond today.

Entity issuing the bond does not matter company's required return, tenure, coupon payments matter

We can assume in the absence of information that this bond will redeem at par value.