Question

2. Riordan Ltd. is expected to pay dividends in the next period (i.e. period 1) of 30% of its expected earnings per share of 40 cents. The company's dividends will then grow by 12% per annum in periods 2 and 3, and 10% per annum in periods 4,5 and 6, before settling down to a perpetual growth rate of 8% per annum. Required :

(a) Calculate the maximum amount which you would be prepared to pay for a Riordan Ltd. share assuming you intend holding it indefinitely, and assuming a required rate of return of 20% (b) Assuming now that you intend purchasing the shares but holding them for only 4 years (rather than indefinitely).

What is your estimate of the current market value of one share? Explain your answer.

Answer 1

D1 = 30% * 40

As it is mentioned that the dividend for year 2 and 3 will grow at 12%

D1 = 12 cents

D2 = 12 * 1.12 = 13.44

D3 = 13.44 * 1.12 = 15.05

As it is mentioned that the dividend for year 4, 5 and 6 will grow at 10%

D4 = 15.05 * 1.10 = 16.56

D5 = 16.56 * 1.10 = 18.21

D6 = 18.21 * 1.10 = 20.04

After year 6 dividend will grow at 8%

D7 = 20.04 * 1.08 = 21.6381

P6 = D7/ (Requred Rate - Growth Rate)

P6 = 21.6381/ (20% - 8%)

P6 = 180.32

Applying dividend discount model

P0 = 12/ (1.20) + 13.44/ (1.20)2 + 15.05/ (1.20)3 + 16.56/ (1.20)4 + 18.21/ (1.20)5 + 20.04/ (1.20)6 + 180.32/ (1.20)6

P0 = 10 + 9.33 + 8.71 + 7.99 + 7.32 + 6.71 + 60.39

P0 = 110.4471

P0 in dollars = $1.10

Part B

P4 = 18.21/ (1.20) + 20.04/ (1.20)2 + 21.6381/ (20% - 8%) * 1/(1.2)2

P4 = 154.3121

P0 = 12/ (1.20) + 13.44/ (1.20)2 + 15.05/ (1.20)3 + 16.56/ (1.20)4 + 154.3121/(1.20)4

P0 = 10 + 9.33 + 8.7111 + 7.985 + 74.417

P0 = 110.4471

P0 = $1.10

In this case we can see that the future cash flow stream and cost of equity are not changing. So the value of the share at time period 0 is not getting changed