Question

a) ABC Ltd is not expected to pay any dividends for the next 3 years. Then the expected dividend is $0.70 per share, which will continue to grow at a constant rate of 25% per annum for another 3 years. After that, the dividend will grow indefinitely at 4% per annum. If the rate of return is 10% per annum, what is the current value of a share in ABC Ltd?

b) If the discount rate is 8%, what is the current value of a preference share with $5 dividends perpetually? (1 mark)

c) Describe three differences between ordinary shares and preference shares.

d) Describe three different forms of efficient market hypothesis.

Answer 1

(a): Here D4 = $0.70, g = 25%. We can find D5, D6 and D7 by using the growth rate of 25%. D8 onwards growth rate will be 4%.

Thus current price = D4/(1+r)^4 + D5/(1+R)^5 + D6/(1+r)^6 + D7/(1+r)^7 + P7/(1+r)^7

Also P7 = D7*(1+g)/(r-g) = 1.3672*1.04/(.010-0.04) = 23.70

Thus current price = $14.50

Year (n)		Dividend amount	1+r	PV = amount/(1+r)^n
4	D4	0.70	1.10	0.48
5	D5	0.88		0.54
6	D6	1.09		0.62
7	D7	1.3672		0.70
7	P7	23.70		12.16
			Current price	14.50

(b): Current price of preference shares = perpetual dividends/discount rate = $5/8%

= $62.50

(c): The primary difference is that ordinary shares (also known as common shares) have a lower priority for company assets and only receive dividends at the discretion of the corporation's management. In other words holders of ordinary shares receive their share of capital only after holders of preference shares are paid in the event of winding up of the company. Also there are no voting rights provided to preference shareholders while ordinary shareholders get voting rights.

(d): There are 3 forms of efficient market hypothesis as explained below:

• Weak efficient market hypothesis - In this form today's stock price reflects all data of past prices. Technical analysis will not be of any help here.
• Strong efficient market hypothesis - In this form all types of information - public and even not public - is incorporated and reflected in today's price of the stocks. Investors cannnot beat the market.
• Semi-strong efficient market hypothesis - In this form public information is part of a stock's current price and so technical and fundamental analysis are of no use.