ABA 320.

SHARES VALUATION

Suggested solution(Offer alternative suggestions)

Q1. The most recent financial data for the Rare Watts disclose the following:
● Dividend per share Kshs.3.00

● Expected annual dividend growth rate 6 percent

● Current required rate of return 15 percent

The company is considering a variety of proposals in order to redirect the firm’s activities.
The following four alternatives have been suggested:
1. Do nothing in which case the key financial variables will remain unchanged.
2. Invest in venture that will increase the dividend growth rate to 7% and lower the
required rate of return to 14%.
3. Eliminate an unprofitable product line. The action will increase the dividend growth
rate to 8% and raise the required rate of return to 17%.
4. Acquire a subsidiary operation from another company. This action will increase the
dividend growth rate to 9% and required rate of return to 18%.
Required:

For each of the proposed actions, determine the resulting impact price and recommend the
best alternative.

1. PO = Do(1+g)/Ke-g
= 3(1.06)/0.15-0.06
=35.33 Shillings

2. PO = Do(1+g)/Ke-g
= 3(1.07)/0.14-0.07
=45.85 Shillings
 3. PO = Do(1+g)/Ke-g
= 3(1.08)/0.17-0.08
=36 Shillings

4. PO = Do(1+g)/Ke-g
= 3(1.09)/0.18-0.09
=36.33 Shillings

I would advice the company to pick the 2nd option as it maximizes the price
impact.

Q2. Andreas Company Ltd. currently pays a dividend of Sh.2 per share and this dividend is
expected to grow at an annual rate of 15% for the first 3 years then at a rate of 10% for the next 3
years after which it is expected to grow at a rate of 5% thereafter.
i. What value would you place on the stock if an 18% rate of return were required?
Valuation for the first year would be;
PO = Do(1+g)/Ke-g
= 2(1.15)/0.18-0.15
=76.67 Shillings

ii. Would your valuation change if you expected to hold the stock for only 3
years? Explain.
The valuation would change if you only hold the stock for 3 years this is because
annual growth of 15% is calculated yearly and the price taken to next year as the
current price thus creating changes in the valuation.

Q3. The stream of dividends of XYZ Ltd for the past 4 years was as follows:
Year 1999 2000 2001 2002
DPS Sh. 2.50 2.65 2.76 2.81

The cost of equity is 14%. Determine the price of a share.

Year 1999 PO = Do/Ke

 = 2.50/0.14 = 17.86 shillings

Year 2000 PO = Do/Ke

= 2.65/0.14 = 18.92 shillings

Year 2001 PO = Do/Ke

= 2.76/0.14 = 19.71 shillings

Year 2002 PO = Do/Ke

= 2.81/0.14 = 20.07 shillings

Eventually accordingly to dividend provided there is a tendency of 10% increment in that case
we can determine the price by;

1. PO = Do(1+g)/Ke-g
= 3(1.1)/0.14-0.1
=82.5 Shillings

BOND VALUATION

Example
K is contemplating purchasing a 3 year bond worth 40,000/= carrying a nominal coupon rate of
interest of 10%. K required rate of return is 6%.
What should he be willing to pay now to purchase the bond if it matures at par?
Solution
Int = 10% x 40,000 = 4,000 p.a.
n = 3 yrs
Kd = 6%
M = 40,000
Vd =
= 4,000 x PVAF6%,3 + 40,000 x PVIF6%,3 = (40,000 x 2.673) + (40,000 x 0.840) = 44,292