Question

Question 3

LogiTel Corp. is a public company which had issued both common stock and cumulative preferred stock. In its recent meeting, management has decided not to pay dividends in the next 3 years.

a) John, a shareholder of LogiTel, is unhappy with the management’s decision and intends to sue the company for not paying dividends. Briefly comment on John’s intention.

b) Briefly explain the cumulative feature of preferred stock.

c) Assume that LogiTel will pay a dividend of $1 per share of common stock at the end of year 4. Dividends are expected to grow at 5% per year in year 5 and 6. After that, dividends will growth at a constant rate of 1% per year indefinitely. Calculate the current common stock price if the required return is 8%.

Answer 1

a. Since John is a shareholder (common stock) of the firm, he can't sue the company for not paying him a dividend as the company is not liable to do so. Shareholders get the residual income left after paying the debt holders and the preferred shareholders at the discretion of the management.

b. The cumulative feature of the preferred stock means that the fixed dividend payable to the holder of this security goes on accumulating for all the years the firm doesn't pay the dividend. Hence, when the firm decides to pay the preference shareholders, the cumulative feature allows the holders to be liable to get the dividend for all the years the firm didn't pay the dividend.

c. Dividends in years 5 and 6 will be 1.05 and 1.1025 respectively (5% growth). So we calculate the terminal value of the future dividends after year 6 by using the Gordon growth formula:

TV = D x (1+g)/(r-g) = 1.1025 x (1.01)/(0.08-0.01) = 15.9075.

Now we discount these cash flows to get the current stock price:

Price = 1/1.08^4 + 1.05/1.08^5 + 1.1025/1.08^6 + 15.9075/1.08^6

Price = 12.1688