Question

a). Compute the current value of a share of common stock of a company whose most recent dividend was RM2.50 and is expected to grow 3% per year for the next 5 years, after which the dividend growth rate will increase to 6% per year indefinitely. Assume 10% required rate of return.

b).You are considering to purchase the stock of Tambunan Tea Bhd. You expect it to pay a dividend of RM3 in 1 year, RM4.25 in 2 years and RM6.00 in 3 years. You expect to sell the stock for RM100 in 3 years. If your required of return for the stock is 12%, how much would you pay for the stock today?

c). A firm owns a building with a book value of RM 150,000 and a market value of RM250,000. If the building is utilized for a project, what would be the opportunity cost (ignore the taxes). Explain your answer.

d). The cost of a new machine is RM250,000. The machine has a 3-year life and zero salvage value. If the cash flow each year is equal to 40% of the cost of the machine, calculate the payback period for the project.

e). Luanti Corp. is considering investing in a new project. The project will need an initial investment of RM2,400,000 and will generate RM1,500,000(before tax) cash flows for three years. If the tax rate is 20%, calculate the IRR for the project.

Answer 1

a. Current value of a share is computed as follows:

Dividend at end of year 1 = RM 2.50 + 3% = RM 2.575

Dividend at end of year 2 = RM 2.575 + 3% = RM 2.652 Approximately

Dividend at end of year 3 = RM 2.652 + 3% = RM 2.732 Approximately

Dividend at end of year 4 = RM 2.732 + 3% = RM 2.814 Approximately

Dividend at end of year 5 = RM 2.814 + 3% = RM 2.898 Approximately

Dividend at end of year 6 = RM 2.898 + 3% = RM 3.072 Approximately

= D1 / 1.10¹ + D2 / 1.10² + D3 / 1.10³ + D4 / 1.10⁴ + D5 / 1.10⁵ +  1 / 1.10⁵ [ D6 / ( required rate of return - growth rate) ]

By plugging the figures in the above mentioned formula we shall get:

= 2.575 / 1.10¹ + 2.652 / 1.10² + 2.732 / 1.10³ + 2.814 / 1.10⁴ + 2.898 / 1.10⁵ + 1 / 1.10⁵ [ 3.072 / (0.10 - 0.06) ]

= 2.34 + 2.192 + 2.053+ 1.922 + 1.799 + 47.687

= RM 57.993 Approximately

So the current value of a share is RM 57.993 Approximately.

b. We would be paying for the stock today as (i.e. we need to compute the present value of dividends and also the present value of selling price)

= 3 / 1.12¹ + 4.25 / 1.12² + 6 / 1.12³ + 100 / 1.12³

= 2.68 + 3.39 + 4.27 + 71.18

= RM 81.52 Approximately

c. The opportunity cost if the building is utilized for other project will be RM 250,000, since if the building is utilized for some other project we will not be able to sell the building at the current market value of RM 250,000, since the opportunity cost is the cost that we have to sacrifice when we are utilizing the building for some other project.

d.Payback period is the period in which we are able to recover our initial investment in a project.

In this case our initial investment is RM 250,000 and we are able to generate cash flows each year of 40% of cost of investment i.e. 40% x 250,000 = RM 100,000.

So as can be seen in 2.5 years we would be able to generate cash flows of

= 2.5 years x 100,000 each year

= RM 250,000

Which is equal to our initial investment in the project, hence our payback period would be equal to 2.5 years.

e. IRR of the project is the rate at which the NPV of the project is zero. in order to compute the IRR, we shall be using the below mentioned formula:

= Lower Rate + [ Lower Rate NPV / ( Lower Rate NPV - Higher Rate NPV ) ] x ( Higher Rate - Lower Rate )

Now lets calculate NPV at a hypothetically rate of 23%

Initial Investment = RM 2,400,000

After tax cash flows each year = RM 1,500,000 - 20%

= RM 1,200,000

= (2,400,000) + 1,200,000 / 1.23¹ + 1,200,000 / 1.23² + 1,200,000 / 1.23³

= RM 13,649 Approximately

Now lets calculate NPV at a hypothetically rate of 25%

Initial Investment = RM 2,400,000

After tax cash flows each year = RM 1,500,000 - 20%

= RM 1,200,000

= (2,400,000) + 1,200,000 / 1.25¹ + 1,200,000 / 1.25² + 1,200,000 / 1.25³

= RM ( 57,600) Approximately

Now feeding these values in the above mentioned formula we shall get IRR as follows:

= 23% + [ 13,649 / ( 13,649 - ( 57,600) ] x ( 25 -23 )

= 23.38 % Approximately

Feel free to ask in case of any query relating to this question