Question

Question 3

The recent trade war has hit the Orange Company severely. Management announced that previous plans to expand its operations would be cancelled. Orange just paid a dividend of $2.50 but announced that next year’s dividend would be cut to $2 per share, and only grow at a rate of 2% per year forever. The market price of the stock was $20 before the announcement. The stock’s expected return is 15%.

(a)Calculate the price of the stock after the announcement based on the constant dividend growth model.

(b)Explain one (1) limitation of the constant dividend growth model.

(c)Briefly discuss two (2) reasons each for an investor to prefer to invest in the convertible bonds of a company over the company’s: (i)Preferred shares(ii)Ordinary shares

Answer 1

A)

V= Value of Stock, D1= Next year expecetd Dividend, k= Required rate of Return, g= Growth Rate

V= D1 / K- g

V=2 / 0.15-0.02

V=15.3846

B)

Limitation of Constant Dividend Model

1. Constant growth model lies in its assumption of a constant growth in dividends per share

2.It is very rare for companies to show constant growth in their dividends due to business cycles and unexpected financial difficulties

C)

For Equity Investor

1.  the advantages of a bond's relative reliability with the option to convert to equity and realize an even greater yield

2. they provide issuers a chance to raise capital at a lower interest rate and delay the dilution of their common stock

3. equity share investment are dividend entitlement

For Preference share Investor

1. they have right to convert the bond into Preference share

2. Preference shares earn higher dividend compared to common shares and also allow them to participate in company's profits

3.As the common shares' price increases, the option to convert becomes valuable

4. Preference shares are less risky than common shares and have priority claim over firm's assets than common shares