Philips plc has just paid a dividend of 10p per share. Next year’s dividend is expected to be 30% higher and thereafter dividends are expected to grow at a rate of 5% per annum. The cost of capital for Philips is 9%. The management of the company is faced with an investment opportunity which will require dividends to be reduced to 5p next year and then thereafter dividends will be as follows: 10p at the end of year 2 10p at the end of year 3 10p at the end of year 4; 23p at the end of year 5; Dividends will then grow at 7% per annum. However, the market believes that the new investment increases the riskiness of Philips plc with the result that the cost of equity capital rises to 12%. Assume that the market is strong form efficient. Consider the following statements. If a decision is taken now to go ahead with the investment the current share price and the share price after 4 years will both be lower. If a decision is taken now to go ahead with the investment the current share price will be higher and the share price after 4 years will be lower. If a decision is taken now to go ahead with the investment the current share price will be lower and the share price after 4 years will be higher. Which of the following is correct? I is correct and the company should not go ahead with the investment II is correct and the company should go ahead with the investment II is correct and the company should not go ahead with the investment III is correct and the company should go ahead with the investment
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.
- Philips plc has just paid a dividend of 10p per share. Next year’s dividend is expected to be 30% higher and thereafter dividends are expected to grow at a rate of 5% per annum. The cost of capital for Philips is 9%. The management of the company is faced with an investment opportunity which will require dividends to be reduced to 5p next year and then thereafter dividends will be as follows:
10p at the end of year 2
10p at the end of year 3
10p at the end of year 4;
23p at the end of year 5;
Dividends will then grow at 7% per annum.
However, the market believes that the new investment increases the riskiness of Philips plc with the result that the
- If a decision is taken now to go ahead with the investment the current share price and the share price after 4 years will both be lower.
- If a decision is taken now to go ahead with the investment the current share price will be higher and the share price after 4 years will be lower.
- If a decision is taken now to go ahead with the investment the current share price will be lower and the share price after 4 years will be higher.
Which of the following is correct?
- I is correct and the company should not go ahead with the investment
- II is correct and the company should go ahead with the investment
- II is correct and the company should not go ahead with the investment
- III is correct and the company should go ahead with the investment
III is correct and the company should not go ahead with the investment
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