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FINM 1001: Money Markets and Finance

Valuing Stocks: Solutions to Practice Questions

Question One

It is January 1996, and the Federal Government is considering the sale of 100% of Telstra.  Telstra’s dividends to the Government are $3 billion per year. Assuming that these dividends continue indefinitely and that the required rate of return is 12% p.a., what is the value of Telstra?

To calculate the value of Telstra as at January 1996 given an expectation that annual dividends will not grow, simply use the present value of a perpetuity formula:

Question Two

Again, it is January 1996, Telstra’s dividend to the Government last year were $3 billion and the annual dividend is growing at the rate of 5% p.a.. Assuming that this is expected to continue indefinitely and that the required rate of return is 12%, what is the value of Telstra?

To calculate the value of Telstra as at January 1996 given an expectation that annual dividends will grow at a rate of 5% p.a., simply use the formula for the present value of a perpetuity with constant growth:

Question Three

What was the value of the dividend paid just paid by a company who’s share price is $3.50 given a required rate of return of 11% p.a. given dividends are expected to grow at a rate of 8% p.a. indefinitely?

To calculate the value of the dividend just paid by the company, simply use the formula for the present value of a perpetuity with constant growth and rearrange to solve for the dividend value:

Question Four

What is the per annum required rate of return on a share whose price is $10 and pays dividends at a rate of $0.75 per annum given dividends are not expected to grow?

To calculate the annual required rate of return on this share, simply use the formula to calculate the present value of a perpetuity with zero growth and rearrange to solve for the required rate of return:

Question Five

Calculate the annual dividend paid by a preference share that currently trades at a price of $35 given a required rate of return of 15% p.a..

To calculate the annual dividend paid by this preference share, simply use the formula to calculate the present value of a perpetuity with zero growth and rearrange to solve for the value of the dividend:

Question Six

A company has just paid a dividend of $0.95 per share.  Dividends paid by the company are expected to grow at a rate of 8% p.a. indefinitely.  Calculate the price of one share in the company if the required rate of return is 9% p.a.

To calculate the price of one share, simply apply the formula used to find the present value of a perpetuity with constant growth: