Question

Question 4 10 Marks (a) Why is share valuation more difficult than bond valuation? Explain. (4 marks) (b) GMX Ltd is a fast-growing company. The company expects to grow at a rate of 25% in the first two years, and then by 10% for the next three years. Followed by this, the company is expected to settle to a constant growth rate of 4%. The first dividend is expected to be paid next year and it will equal $4. What is the value of this share, given that an investor's required rate of return for the share is 17% p.a.? (3.5 marks) (c) An investor owns share of KMP Ltd. The company recently paid a dividend of £5. It is expected that the company will grow at a constant rate of 5% for the foreseeable future. What is the value of the share, if the investor's required rate of return for the share is 10% p.a.? If the current market price of the share is £110, is the share a desirable purchase? (2.5 marks)

Answer 1

(a)

Shares valuation is more difficult to value because

(i) Stocks do no have maturity value. Whereas, bonds have maturity value.

(ii) Bonds valuation becomes easier than stocks' because the bond holder receives full coupon payment. But for stock holders the dividends vary depending on the profits earned by the company.

(iii) Stock market is more volatile than the bond market.

(iv) Bonds have quantifiable attributes that are used in valuation whereas, stocks doesn't.

(v) Bonds have maturity date and predetermined cash payments whereas, stocks doesn't.

(b)

All the calculations are shown in below images. As dividend of next year is already given, it is directly used without including growth rate.

sol (b) Giren, biridend paid next year, Di= $4. gi = 25% for 3 years g lot for next years, gz - 4% for forever. * = 11% pa Value of D + + Dn & Pn the share. THER) (Hrte (train (Arts When, Donde - iDn are deridends of respective slock, Prie price at the end of stock. Da. Di (Hg.) = $4x11 +0.25) $5 . Dz=D2 (1492) = $5*(1 +0.1) = $5.5 Dq = D3 (1492) - $5.5*(1+0.1) = $6.65 DS: D4 (1493) - $6.05(1401) - $6.655.- Ps= D6 DSX (1+93) 6.655*(1 to of) (*) (** *73) (0-17-0.04) Ps - $5324. As directly dridend of next value is girent, the growth of 25% is a directly shown in the ralue. As der udendo grow @ 4% for forever, instead of calculating bridend price at the end (ps) is calculated

year (i) o ? D = A 3.452 3.655 Cashflows present value factor ci (4) @ 17% (ritrksi) | (1407) - 0.855 De 56 I ((to.lu -0.731 D3 See Tho.3 0.624 Do ²6.05 (to 1734 ² 0.534 D5=6.655 (Holy 0.456 PS = 53.24 Cito 115 0.456 3.432 3. 231 3.035 24.271 e value of the (cax- (tik Share is $41.082
(c)

e Giren, toerer. Do = $25... lo. g = st. for forever * = 10top.a Po= £110,

IN = D. Do (149) 5*(1+0.05) €105. 0.1-0.05 As consent puce is the loo is greater - value of the share or e.. sh 105 , it is not desirable to purchase the share