Question

a) You are currently thinking about investing in an ordinary share The share recently paid a dividend of $2.25 and the dividend is expected to grow at a constant rate of 5 per cent p.a. You normally require a return of 14 % p.a. on shares of similar risk.Calculate the value of the share using the Dividend Discount Model (DDM).

(b) Ambrose Ltd expects to pay a dividend of $5.90 per share next year. The dividend is then expected to grow by 10% per annum for years 2 and 3. After that (year 4 and beyond), the dividend is expected to grow at 3% p.a. indefinitely. Calculate the value of the share using the super-normal/multi-stage Dividend Discount Model assuming shareholders require a return of 13% p.a.

c)A preference share has a par value of $100 and pays a dividend of 5% of par each year. It currently trades at a price of $33.75 per share. Calculate the shareholders required annual rate of return (as a percentage to two decimal places)

Answer 1

a) Calculation of share price using DDM :-

Value of share = D0 (1+g) / r-g)

Here D0 = Dividend just paid or paid last year

g = growth rate

r = required rate of return

Value of stock = 2.25 * 1.05 / (0.14 - 0.05) = $ 26.25

b) Here D1 = $ 5.90

D2 = D1 * (1+g) = 5.90 * (1.10) = $ 6.49

D3 = D2 * (1+g) = 6.49 *( 1.10) = $ 7.139

From D4 growth rate is 3% indefinitily, so we calculate value of share price at year ended D3

Value of share at year ended D3 = D3 * (1+g) / r - g)

= 7.139 *(1.03) / (0.13 - 0.09) = $ 73.5317

Value of share todays means present value of all cash flows from the stock.

Value of stock today

Years	Dividends	PVF@13%	PV of dividends
1	5.9	0.88495575	5.22123894
2	6.49	0.78314668	5.08262198
3	7.139	0.69305016	4.94768511
3	73.5317	0.69305016	50.9611566
Value of stock today	66.2127026

:-Value of stock today = $ 66.21

c) required return = Preferred dividend / stock price = 100 * 5% / 33.75 = 5 / 33.75 = 14.815%