Question

Week 8 – Question 2 a. Briefly discuss the relationship between the following: (Word limit 50-70 words) i. Share price and investors required rate of return ii. Share price and divided growth rate b. Otama LTD has an issue of preference shares outstanding that pays a $2.85 divided every year. If this issue currently sells for $77.32 per share, what is the required return? c. Price Tigers LTD expects to pay a $3.25 per share dividend next year. The company pledges to increase its dividend by 5.1% per year, indefinitely. If you require a return of 11% on your investment, how much will you pay for the company’s share?

Answer 1

1.
If required return of the stock increases, it means the stock becomes riskier and hence to compensate for the risk the required return is higher. According to the formula

P=D1/(r-g)

Price is inversely proportional to required return. So, when required return increases price decreases and vice versa

2.
Higher growth rate means higher cash flows for the investor. According to the formula

P=D0*(1+g)/(r-g)

Price is directly proportional to growth rate. So, when growth rate increases price increases and vice versa

3.
Required return=Dividend/Price=2.85/77.32=3.686%

4.
Price=Expected Dividend/(required return-growth rate)=3.25/(11%-5.1%)=55.08474576