Equities investment problem.

Question

Investor A wants to invest in Company XYZ. Company XYZ’s shares are trading at R220 per share. The company is expected to pay a dividend of $15 per share at the end of the year. Thereafter, dividends are expected to grow by 10% per year for the next two (2) years (i.e. the short term), and then grow by 5% into perpetuity. The cost of equity for the company is 12%.

a) Calculate the terminal value

b) Determine the intrinsic value of Company XYZ’s share.

Answer 1

The two-stage dividend discount model comprises two parts and assumes that dividends will go through two stages of growth. In the first stage, the dividend grows by a constant rate for a set amount of time. In the second, the dividend is assumed to grow at a different rate for the remainder of the company's life.

In this case, 2 years the company's dividends grow at 10% and afterwards at 5% indefinitely.

D1=$15

D2=15*(1+10%)=16.5

D3=16.5*(1+10%)=18.15

TV=18.15*(1+5%)/(12%-5%)=272.25

Intrinsic value of Company XYZ’s share=sum of discounted dividends and terminal value

P=15/(1+12%)^1+16.5/(1+12%)^2+18.15/(1+12%)^3+272.25/(1+12%)^3=233.25