Question

Describe how you would approach finding the present value of a company with nonconstant dividends. Would simply using the same method to find present value with constant dividend growth yield inaccuracies? What would they be? (Nota bene: simply noting or referring to formulae is insufficient.)

Answer 1

PV=D1/(1+ke) +D2/(1+ke)^2 +.........+Dn/(1+ke)^n+ Pn/(1+ke)^n

Where PV=Present value

D1=Dividend as per share

Ke= cost of equity capital

Pn= market price of the share in the n^th year (year in which share are sold)

Yes, We can't use the same equation for constant and nonconstant dividends to find out PV because the value will vary as per the change in dividend. So that we have to calculate PV or present value using the above formula. There will be different growthrate in case of nonconstant dividends so that we have to find out Dividend amount of each year using the formula

D1=D0 (1+g)

D2=D1 (1+g) where D1 =expected dividend at the end of the year

D0=Previous year's dividend

Here is an example,

Equity shares of a company are currently selling at Rs.128 each. It is currently paying a dividend of Rs.7.25 per share. The dividend is expected to grow at 12% for six years and at 6% thereafter.Compute the cost of equity

SOLUTION

Computation of dividend

Year Dividend

0 7.25

1 8.12

2 9.09

3    10.18

4 11.41

5 12.77

6 14.31

D1=D0 (1+g) , = 7.25 (1+0.12) =8.12

D2=D1 (1+g) likewise you can find out the dividend of the 6 years =8.12 (1+.12)=9.09