SELF-TEST PROBLEMS

6.1 Dividend growth and share valuation

Development Company has just paid a cash dividend of $0.20 per share. Investors require
a 16 per cent return from investments such as this.
a) If the dividend is expected to grow at a steady 8 per cent per year, what is the current
year value of a share?
D0 r g
$0.2 16% 0.08

$ 0.2 x (1+0.08)
 P0 = = $2.7
0.16−0.08

b) What will a share be worth in 5 years?

D0 r g
$0.2 16% 0.08

D6 $ 0.2 x (1+0.08)6
 P5 = = = $3.97
r−g 0.16−0.08

6.2 More dividend growth and share valuation

In Problem 6.1, what would a share sell for today if the dividend is expected to grow at 20
per cent for the next 3 years and then settle down to 8 per cent per year?
D0 = $0.2, g =0.20
D1 = $0.2 x (1+0.2)1 = $0.24
D2 = $0.2 x (1+0.2)2 = $0.288
D3 = $0.2 x (1+0.2)3 = $0.3456
D4 $ 0.3456 x (1+0.08)
P3 = = = $4.67
r−g 0.16−0.08

 P0 = $3.63

6.3 Bond values

A bond has a 10 per cent coupon rate and a $100 face value. Interest is paid semi-annually,
and the bond has 20 years to maturity.
a) If investors require a 12 per cent yield, what is the bond’s value?
FV n I PV PMT
$100 20 x 2 = 40 12% / 2 = 6% $84.95 (10% / 2) x $100 = $5
b) What is the effective annual yield on the bond?
0.12
Y = (1+( )¿ ¿2 – 1
2
Y = 0.1236
Y = 12.36%

6.4 Bond yields

A Property Ltd bond carries an 8 per cent coupon, paid semi-annually. The face value is
$100, and the bond matures in 6 years.
a) If the bond currently sells for $91,137, what is its yield to maturity?
FV n I PV PMT
$100 6 x 2 = 12 5% $91.137 (8% / 2) x $100 = $4

b) What is the effective annual yield?

0.08
Y = (1+( )¿ ¿2 – 1
2
Y = 0.0816
Y = 8.16%

QUESTIONS AND PROBLEMS

1 Prices versus interest rates
a) What is the relationship between changes in interest rates and bond values?
It is an inverse relationship. When interest rate increases, the bond value decreases. When
interest rate decreases, the bond value increases.

b) How is this relationship affected by the time to maturity? By the coupon rate?
The longer the time to maturity, the greater the change in bond values for a given change in
interest rates (YTM), all else being equal.
(In other words, the longer the time to maturity, the higher the interest rate risk. Thus, the
impact of interest rate risk on bond value will be higher, all else being equal.)

The lower the coupon rate, the greater the change in bond values for a given change in
interest rates (YTM), all else being equal.
(In other words, the lower the coupon rate, the higher the interest rate risk and the higher the
impact on bond value.)
2 Bond yields
Issued bonds have a price of $91.77 and a coupon rate of 10 per cent paid annually. The
bond will mature in 6 years. What is the yield to maturity?
FV n I PV PMT
$100 6 12% $91.77 10% x $100 = $10

5 Bond values
Pat Instruments has a bond issue outstanding that pays $8 annually. It has a face value of
$100, and it will mature in 6 years. Similar bonds are priced to yield 9 per cent. What
would you expect this bond to sell for?
FV n I PV PMT
$100 6 9% $95.51 $8

7 Share values and growth

Shrink Ltd has experienced a steady growth of 6 per cent per year in its annual dividend.
This growth is expected to continue indefinitely. The last dividend paid was $0.17 per
share. Investors require a 12 per cent return on similar companies.
a) What is the current price of Shrink Ltd shares?
D0 r g D1 P0
$0.17 12% 6% $0.17 (1+0.06) = $0.1802 $0.1802 / (0.12 – 0.06) = $3

b) What will the price be in 4 years?

D0 r g D5 P4
$0.17 12% 6% $0.17 (1+0.06)5 = $0.2275 $0.2275 / (0.12 – 0.06) = $3.79

10 Required returns
SALT Ltd shares currently sell for $3 per share. The last dividend was $0.20 per share.
The dividend is expected to grow at 5 per cent.
a) What is the required return on SALT shares?
D0 r g D1 P0
$0.20 12% 5% $0.20 (1+0.05) = $0.21 $3
 P0 = $3
D1
= $3
(r −g)
$ 0.21
= $3
(r −0.05)
r – 0.05 = 0.07
r = 0.12
 r = 12%

b) The dividend yield?

Dividend yield = D1 / P0
= $0.21 / $3
= 0.07

12 Semi-annual coupons
Hope bonds have a coupon rate of 7 per cent and mature in 7 years. Assuming semi-annual
coupons, what is the value of this bond? Similar bonds yield 6 per cent. Assume the face
value of the bond is $100.
FV n I PV PMT
$100 7 x 2 = 14 6% / 2 = 3% $105.65 (7% / 2) x $100 = $3.50

13 Calculating yields
In Problem 12, what would be the value of the bond if similar bonds yield 8 per cent?
FV n I PV PMT
$100 7 x 2 = 14 8% / 2 = 4% $94.72 (7% / 2) x $100 = $3.50

16 Calculating required return

Old Equipment anticipates a dividend growth rate of 4 per cent forever. The market
required return is 20 per cent on similar securities. The next dividend is predicted to be
$0.152 per share. What is the current price per share?
r g D1 P0
20% 4% $0.152 $0.152 / (0.2-0.04) = $0.95

24 Non-constant growth
Green Ltd has just paid a $0.40 dividend. The dividend is expected to grow at 12 per cent
for the next four years. After that, the growth rate will be 4 per cent indefinitely. If the
required return is 16 per cent, what is the current value of a share today?
D0 = $0.4, g = 0.12
D1 = $0.4 x (1+0.12)1 = $0.448
D2 = $0.4 x (1+0.12)2 = $0.5018
D3 = $0.4 x (1+0.12)3 = $0.5620
D4 = $0.4 x (1+0.12)4 = $0.6294
D5 $ 0.6294 x(1+ 0.04)
P4 = = = $5.45
r−g 0.16−0.04

 P0 = $4.48

27 Perpetuities
a) What is the value of an asset that pays $4 per year forever? Assume a 20 per cent
required return.
Value = PMT / r = $4 / 0.2 = $20

b) How would your answer change if the cash flow grows at a rate of 5 per cent per
year forever? Assume that $4 was the most recent payment.
Value, P0 = D1 / (r-g) = D0 (1+g) / (r-g) = $4 (1.05) / (0.2 – 0.05) = $28

29 Capital gains versus dividends

This is a challenge problem.
You have predicted the following dividends for the next three years on import Ltd’s shares:
Year Projected Dividend
1 $0.20
2 $0.30
3 $0.40

Beginning in the third year, you project that the dividend will grow at an 8 per cent rate
indefinitely. The required return is 15 per cent.
a) Calculate the price today for the shares.
D1 = $0.20
D2 = $0.30
 D3 = $0.40
D4 $ 0.40 x (1+0.08)
P3 = = = $6.17
r−g 0.15−0.08
 P0 = $4.72

b) Calculate the price at years 1, 2 and 3.

D2 D3 P3 $ 0.30 $ 0.40 $ 6.17
P1 = 2 + 3 + 3 = 2 + 3 + 3 = $4.55
(1+r ) (1+r ) (1+r ) (1.15) (1.15) (1.15)
D3 $ 0.40
P2 = = = $5.71
r−g 0.15−0.08
P3 = $6.17

c) Calculate the dividend yield and capital gains yield in each of the first four years. What
do you observe?
Year Dividend Yield Capital gains yield
1 $0.20 / $4.72 = 4.24% ($4.29 – $4.72) / $4.72 = – 0.0911
2 $0.30 / $4.55 = 6.6% ($5.71 – $4.29) / $4.29 = 0.331
3 $0.40 / $5.71 = 7% ($6.17 – $5.71) / $5.71 = 8%
4 $0.432 / $6.17 = 7% ($6.67 – $6.17) / $6.17 = 8%

Note that the dividend yield and capital gains yield should always add up to 15%, same as the
required rate of return