Question

2. a) It is 1 July 2022. Martins plc has gone through a period of retrenchment which has meant that for the last six years dividends have been held constant at 5p per share per annum. A dividend of 5p per share has been paid on the 30 June 2022. The market expects the annual dividends to remain at this level for the next three years (the next dividend is due in one year's time) and then to increase at a rate of 5% per annum thereafter. The cost of equity capital for Martins pic is 10% per annum. Later in the day, Martins plc announces a lucrative new partnership deal with Finlay plc which it expects will significantly affect future dividends. The market revises its expectations of future dividends as follows: Expected dividend on 30 June 2023 Expected dividend on 30 June 2024 Expected dividend on 30 June 2025 Expected dividend on 30 June 2026 Expected dividends on 30 June 2027 will be 6% higher than the 2026 figure and growth of 6% per annum is expected from then on. Op 7p 10p 10p However, the market believes that the partnership increases the riskiness of Martins plc with the result that the cost of equity capital rises to 14%. () Use a dividend share valuation model to determine the impact of the new partnership on the current share price. (You will need to calculate the share price before and after the (7 marks) (i) Given your calculations in part (0, discuss whether Martins should go ahead with the new partnership and discuss whether the dividend valuation model is useful for valuing (5 announcemont). shares. marks) (0 You are asked to put a value on a bond which promises eight annual coupon payments of £50 and will repay its face value of £1000 at the end of eight years. You observe that other similar bonds have yields to maturity of 9 per cent. How much is this bond worth? (4 marks) b) (ü) You are offered the bond from part (0) for a price of £756.5. What yield to maturity does this represent? (4 marks) c) Define and explain the three forms of the efficient market hypothesis and give examples of the types of information which is incorporated in prices if markets are officient at each of the three levels. (10 marks

Answer 1

a-i). Share price before the announcement:

Formula	Time (n)	1	2	3	4 (Perpetuity)
	Year	30-Jun-23	30-Jun-24	30-Jun-25	30-Jun-26
	growth rate (g)				5%
	Dividend (D)	5.00	5.00	5.00	5.25
D4/(k-g) where k = 10%	Perpetuity value				105.00
	Cash flows (CF)	5.00	5.00	5.00	105.00
1/(1+k)^n	Discount factor @ 10%	0.909	0.826	0.751	0.751
(CF*Discount factor)	PV of dividends	4.55	4.13	3.76	78.89
Sum of all PVs	Price per share	91.32

Share price after the announcement:

Formula	Time (n)	1	2	3	4	5 (Perpetuity)
	Year	30-Jun-23	30-Jun-24	30-Jun-25	30-Jun-26	30-Jun-27
	growth rate (g)					6%
	Dividend (D)	-	7.00	10.00	10.00	10.60
D5/(k-g) where k = 14%	Perpetuity value					132.50
	Cash flows (CF)	-	7.00	10.00	10.00	132.50
1/(1+k)^n	Discount factor @ 14%	0.877	0.769	0.675	0.592	0.592
(CF*Discount factor)	PV of dividends	-	5.39	6.75	5.92	78.45
Sum of all PVs	Price per share	96.51

The new partnership will have a positive impact on current share price and it will increase by 96.51 - 91.32 = 5.19

a-ii). The partnership will result in higher value for the company as evidenced by the increased share price so it can go ahead with the partnership.

Dividend valuation mode, also known as the Dividend Discount Model (DDM) is useful for valuing shares.It is based on the fact that the share price is equal to the sum of the present values of all future cash flows (or dividend payments). Share price can also be calculated using the discounted free cash flow method but for that financial projections are needed which are challenging to forecast. In contrast, DDM is simple to forecast and easy to use. Hence, it is a popular model for valuing a company's share price.

b-i). Use a financial calculator to solve this, as follows:

FV (or par value) = 1,000; PMT (or coupon payments) = 50; N (or number of payments) = 8; Rate (or YTM) = 9%, solve for PV.

PV = 778.61 (Current bond price)

b-ii). Again, using a financial calulator:

PV (or current bond price) = -755.5; FV (or par value) = 1,000; PMT (or coupon payments) = 50; N (or number of payments) = 8, solve for RATE.

YTM (or rate) = 9.50%