Question

Shares and Bonds Valuation

US-China Trade War has affected Unlucky firm recently. Unlucky firm has announced that next year's dividend will be $1 per share and is expected to decrease at a rate of 6% forever.

Market price of stock has declined to $3.50 when this development was disclosed.

Find out the expected return investors hope to get from investing in the stock based on constant dividend growth model and explain one disadvantage of using this model approach.

Discuss 2 reasons why retail investors would invest in the ordinary shares of Unlucky firm compared to the firm's:

i) Preferred shares

ii) Bonds

Answer 1

Current Share price (P.) ' + Ке- where Dia Dividend for next year ke. Cost of equity 9. growth rate 2 $3.5 2 Prolongan Ke- 60.06) 81 Ke-(-0.06) Ke+0.06 = $1 $ 3.5 Since growth rate is decreasing Ke = $3.5 11 – 0.06 a 22.57% Equity - Expected return for investors - 22.57% cost of Major disadvantage of Dividend growth model is Investors will assume aliout the dividends at higher earnings will lead to higher and vice-versa. The dividendi are un certain even if growth rate is good because company may not pay the dividend for using for future growth earnings i inny investor prefer ordinary shares over p. Share and Bonde. in Equity share holder having voting Rights (2 Even though the growth rate is declining the ke is 22.57% (reasonably high) and Retail Investors won't be earning such high relians un preference shares and Bonds.