Question

Alice Walter has never invested in shares before. She has come to you, as a prospective finance graduate, for some advice. In your conversations with Alice, you have determined her Required Rate of Return (RRR) to be 8.25%.

a) Determine the value of a share in BBB Ltd. if they paid a dividend of $0.5 this year and the dividend is expected to grow by 4.5% indefinitely.

Show formula, variables, calculation and a concluding statement in your response.

b) Determine the value of a share in CCC Ltd. if in the current year they paid a dividend of $0.75 and this is not expected to change into the foreseeable future.

Show formula, variables, calculation and a concluding statement in your response.

c) If the market price for each share in parts a) and b) is $10 per share, should Alice buy either or both shares? Justify your answer.

d) Alice decided to buy 100 000 shares in GGG Ltd., giving her 1.5% ownership in the company (GGG Ltd. currently has 15 000 000 issued shares). One year later, GGG Ltd. announces a private placement of a further 10,000,000 shares, in order to raise funds for their new venture: Project COVID.

(i) Describe two features of a private placement of shares. (1 mark)

(ii) What is the major disadvantage to Alice of the above private placement? Include in your answer the effect on her ownership. (1 mark)

(iii) Identify one other source of equity funding Alice, as a shareholder, would prefer. Justify your choice.

Answer 1

(a): Here D0 = 0.5,r = 8.25% and g = 4.5%. Thus share price = D0*(1+g)/(r-g)

= 0.5*1.045/(0.0825-0.045)

= $13.93

Thus the value of a share in BBB is $13.93

(b): Here D0 = 0.75,r = 8.25%. Thus share price = D1/r. Note that D1 will also be 0.75

= 0.75/0.0825

= $9.09

Thus the value of a share in CCC is $9.09

(c): If the market price for both BBB and CCC is $10 then Alice should buy BBB because its fair value is $13,93 and hence it is undervalued in the market. As such it gives Alice a chance to see an increase in her investment value as there is an upside potential for BBB.

(d) (i): Two features of private placement of shares are – the shares will not be offered publicly and the shares will not have to be registered with the SEC.

(ii): The major disadvantage to Alice is that after the private placement her ownership percentage in GGG will fall. This is because the number of issued shares will increase.

(iii): Alice will prefer a rights offering (or a rights issue) as it will enable her to acquire additional shares of GGG at a discounted price. It should be noted that rights issue will give existing shareholders a right to buy additional shares. It will also not dilute Alice's shareholding or ownership.