Question

The recent trade war has hit the Huaway company severely. Management announced plans to scale down its operation. Huaway announced that next year's dividend will be $1 per share which is expected to decrease at the rate of 6% forever.

The market price of the stock fell to $3.5 when this development was disclosed.

i) calculate the expected return investors hope to get from investing the stock based on the constant dividend growth market.

ii) explain 1 limitation of the constant dividend growth market

iii) Briefly discuss 2 reasons for investing in ordinary shares of a company compared to the company's

a) preferred shares

b) bond

Answer 1

1. Expected return from investors is cost of equity(ke) to the company.

By applying dividend discount model

P=D1/ke-g

3.5=1/ke-(-0.06)

ke+0.06=1/3.5

ke = 0.2857-0.06

ke =0.2257

Therefore cost of equity ke =22.57%.

2. One of the limitation in constant dividend growth market is uncertainty of growth rate.

The growth rate we considered in this period may not be same in future which results in failure of pricing the share.

The growth rate is highly sensitive with respect to both macro and micro economic factors prevailed in economy and the industry in which company operates.

The growth rates affects the cost of equity, and expectations of investors.

3.

a. Ordinary shares vs preference shares

Ordinary shares or equity shares creates ownership interest and voting rights in the company which is not possible for preference shares.

The ultimate profits are enjoyed by equity share holder in the form of dividend or capital appreciation of share value, in preference shares only fixed dividends are paid,no share in profits of the company.

b. Ordinary shares vs bond

Ordinary shares creates ownership interest in the company, debt won't create any such rights.

Profits are shared by shareholders whereas only fixed interest is paid in case of bonds.