Question

The company is currently focusing to expand its business units therefore it needs extra funds to purchase new assets. The company has already issued both preferred and common stock in the market. company is able to sell 18% preferred stock issue at Rs.100 par value and the required rate of return on this investment is 15%.

However the demand of company’s Common stock is increasing day by day in the market. The Company’s financial highlights show that it has announced Rs. 6 dividend on common stock this year. According to investor expectations it would grow at the rate of 5% for next 3 years, then at the rate of 6% for next 3 years and then at the rate of 7% thereafter. If required rate of return of investor is 14%.

Calculate the intrinsic value of share.

Answer 1

Intrinsic value means fair value of share.

As per the given information in the question, we will calculate intrinsic value by using dividend discounting model(DDM).

Under DDM, we discount the future expected dividends using the required return of investors.

Formula will be as follows:

Po = Present value of(D1,D2,D3,D4,D5,D6 and value of all future dividend at year end 6)

Where, Po is fair value of share

D1,D2,D3,D4,D5,D6 are expected future dividends

Calculation of future dividends,

Dividend at year end 1, D1 = Do+g, where Do is previously announced dividend and g is growth rate for given year.

D1 = Rs. 6 + 5% = Rs. 6.3

Dividend at year end 2, D2 = D1+g

D2 = Rs. 6.3+ 5% = Rs. 6.62(rounded off to two decimal points)

Dividend at year end 3, D3 = D2+g

D3 = Rs. 6.62+ 5% = Rs. 6.95(rounded off to two decimal points)

Dividend at year end 4, D4 = D3+g, now g will be 6% as it is fourth year

D4= Rs. 6.95+ 6% = Rs. 7.37(rounded off to two decimal points)

Dividend at year end 5, D5 = D4+g

D5 = Rs. 7.37+ 6% = Rs. 7.81(rounded off to two decimal points)

Dividend at year end 6, D6 = D5+g

D6= Rs. 7.81+6% = Rs. 8.28(rounded off to two decimal points)

Dividend at year end 7, D7 = D6+g, now g will be 7% as it is seventh year and the same g will prevail for life

D7 = Rs. 8.28+7% = Rs. 8.86(rounded off to two decimal points)

Value of all discounted dividends from 7 years to infinity at the growth rate of 7% with 14% of required return of investor will be as follows

Value at year end 6 of all future dividend = D7/Kr-g

Value at year end 6 of all future dividend = Rs.8.86/(0.14-0.07) = Rs. 126.57(rounded off to two decimal points)   

Now these values will be discounted at the investor's required rate of return

Po = PV of (Rs. 6.3,Rs. 6.62,Rs. 6.95,Rs. 7.37,Rs. 7.81,Rs. 8.28 and Rs. 126.57)

Po = Rs.6.63*PVF(14%,1year)+ Rs.6.62*PVF(14%,2year)+ Rs.6.95*PVF(14%,3year)+ Rs.7.37*PVF(14%,4year)+ Rs. 7.81*PVF(14%,5year)+(Rs. 8.28+Rs. 126.57)*PVF(14%,6year)

Po = Rs.6.63*0.8772+ Rs.6.62*0.7695+ Rs.6.95*0.6750+Rs.7.37*0.5921+Rs.7.81*0.5194+Rs.134.85*0.4556

Po = Rs. 85.46 (rounded off to two decimal points)

Price = Rs. 85.46

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