Question

Sammuel Kam and Ahmad Razzi are senior vice-presidents of Berjaya Mutual Berhad. They are co-directors of the company’s pension fund management division, with Mr. Kam having responsibility for fixed income securities (primarily bonds) and Mr. Ahmad being responsible for equity investment. A new major client, the Northeastern Alliance Inc., has requested that Berjaya Mutual Berhad present an investment seminar, and Mr. Kam and Mr. Ahmad, who will make the actual presentation, have asked you to help them. To illustrate the common stock valuation process, Mr. Kam and Mr. Ahmad have asked you to analyse Digit Force Sdn. Bhd., an employment agency that supplies word processor operators and computer programmers to businesses with temporarily heavy workloads.

Questions 1. Briefly describe the legal rights and privileges of becoming a common stockholder.

2. What is a constant growth stock? Is it possible for a company to have a constant growth (g) which exceed its required rate of return (rs)? If it does, what will happen to the company’s stock?

3. Calculate the required rate of return for Digit Force Sdn. Bhd. considering the risk-free rate of 6.5 percent and the market risk premium of 5 percent. The company has a beta coefficient of 1.3.

4. As a constant growth company, Digit Force Sdn. Bhd. paid its last dividend at $1.25. The dividend is expected to grow indefinitely at a rate of 6.35 percent; a. Calculate the firm’s expected dividend stream over the next three years. b. Calculate the firm’s current stock price. c. Calculate the firm’s stock price one year from now. d. Calculate the expected dividend yield, the capital gain yield and the total return during the first year.

5. Using the same information from Question 4, consider the stock is currently priced at $25.75 What is its expected rate of return?

6. Now consider the dividends were expected to have zero growth, what will be the price of the stock?

7. Consider an extreme condition. For instance, Digit Force Sdn. Bhd. is expected to experience a supernormal growth of 35 percent for the next 4 years, after which it will return to its long-run constant growth rate of 6.35 percent. Calculate the value of the stock under this condition. Also calculate its expected dividend yield and capital gain yield for year 1 and year 4.

Answer 1

The legal right of a shareholder are

1. to receive the dividend when declared by the company,

2. to caste a vote in the annual general meeting held by the company,

3. to recommend suggestions to other shareholders matters that need to put on the meeting for a vote,

4. Ownership in the company,

5. Right to transfer ownership

Answer to part 2. A constant growth stock is a stock which grows at a fixed rate over a period of time. It is possible for a company to grow at a constant rate and if it does the market price of its stock will keep on increasing as it will always exceeds its investors return expectation.

Answer to part 3.

Required rate of return is given by Re = Risk free rate + Beta (Market risk premium)

= 6.5 + 1.3(5) = 6.5 + 6.5 = 13%

Answer to part 4.

Dividend last year = $1.25 and is expected to grow at 6.35%

therfore the stream of dividend will be

Y1 = $1.25 + 6.35% = $1.329

Y2 = $1.33 + 6.35% = $1.41

Y3 = $1.41 + 6.35% = $1.50

Assumption the return on equity is assumed 13% as calculated above growth is 6.35%

Therfore the price = Expected Dividend / (Return on equity - Growth)

= 1.329 / 0.0664 = $20

Price of a stock 1 year from now = P2= Dividend of Y2 / (return on equity - growth rate)

= 1.41 / 0.0664 = $21.23

Dividend Yield ratio for year 1 = 1.329 / 20 = 6.65%

Capital gain yield = (21.23 -20) / 20 = 6.15%

Total return during the year = Dividend yield + Capital Gain yield = 6.65 + 6.15 = 12.8%

Answer to part 5.

Price = Expected dividend / (Return on equity - growth rate)

25.75 = 1.329 / (Ke - 0.0635)

Ke = 1.329 / 25.75 + 0.0635 = 11.51%