Little Oil has 1 million outstanding shares with a total market value of $20 million. The firm is expected to pay $1 million of dividends next year, and thereafter the amount paid out is expected to grow by 5 percent a year in perpetuity. Thus the expected dividend in year 2 is $1.05 million, and so on. However, the company has heard that the value of a share depends on the flow of dividends, and therefore it announces that next year’s dividend will be increased to $2 million and that the extra cash will be raised immediately by a simultaneous issue of new shares. After that, the total amount paid out each year will be as previously forecasted, i.e., $1.05 million in year 2 and increasing by 5 percent a year in each subsequent year. Capital markets are perfect. The discount rate for equity for this company is 10%. a) At what price will the new shares be issued in year 1? b) How many shares will the firm need to issue? c) What will be the expected payments on these new shares, and what therefore will be paid out to the old shareholders after year 1? d) Show that the present value of the cash flows to current shareholders remains $20 million.
Dividend Valuation
Dividend refers to a reward or cash that a company gives to its shareholders out of the profits. Dividends can be issued in various forms such as cash payment, stocks, or in any other form as per the company norms. It is usually a part of the profit that the company shares with its shareholders.
Dividend Discount Model
Dividend payments are generally paid to investors or shareholders of a company when the company earns profit for the year, thus representing growth. The dividend discount model is an important method used to forecast the price of a company’s stock. It is based on the computation methodology that the present value of all its future dividends is equivalent to the value of the company.
Capital Gains Yield
It may be referred to as the earnings generated on an investment over a particular period of time. It is generally expressed as a percentage and includes some dividends or interest earned by holding a particular security. Cases, where it is higher normally, indicate the higher income and lower risk. It is mostly computed on an annual basis and is different from the total return on investment. In case it becomes too high, indicates that either the stock prices are going down or the company is paying higher dividends.
Stock Valuation
In simple words, stock valuation is a tool to calculate the current price, or value, of a company. It is used to not only calculate the value of the company but help an investor decide if they want to buy, sell or hold a company's stocks.
Little Oil has 1 million outstanding shares with a total market value of $20 million. The firm is expected to pay $1 million of dividends next year, and thereafter the amount paid out is expected to grow by 5 percent a year in perpetuity. Thus the expected dividend in year 2 is $1.05 million, and so on. However, the company has heard that the value of a share depends on the flow of dividends, and therefore it announces that next year’s dividend will be increased to $2 million and that the extra cash will be raised immediately by a simultaneous issue of new shares. After that, the total amount paid out each year will be as previously
-
a) At what price will the new shares be issued in year 1?
-
b) How many shares will the firm need to issue?
-
c) What will be the expected payments on these new shares, and what
therefore will be paid out to the old shareholders after year 1?
d) Show that the
Trending now
This is a popular solution!
Step by step
Solved in 6 steps
