Strategic Financial Management

Valuation of Business

Dividend Growth Model

P = D0(1+g)/Ke-g P = market price of the share Do = Current year dividend Ke = Cost of equity capital (expected rate of return) g= constant annual growth rate of dividends

 Problem 1: R Ltd is an established company having its shares quoted in the major stock exchanges. Its share current market price after dividend distributed at the rate of 21% p.a. having a paid up shares capital of Rs. 50 lakhs of Rs. 10 each. Annual growth rate in dividend expected is 3%. The expected rate of return on its equity capital is 16%. Calculate the value of R Ltds share based on dividend growth model. Solution

Dividend distributed during the year = Rs. 5000000*0.21 = Rs. 1050000 Value of Business = Do(1+g)/Ke-g = 1050000(1+0.03)/0.16- 0.03 = 83,20,000 Value per share = 8320000/500000= Rs. 16.64

Walters Valuation Model

P = {D+(Ra/Rc)(E-D)}/Rc P= Market Price of the Equity Share D= Dividend per share E= Earnings per share E-D= Retained earnings per share Ra= Internal rate of return on the investment Rc= Cost of capital

 Problem 2: Calculate the market price of ABC Ltds share under Walters Model
Earnings per share Dividend per share Cost of Capital Internal rate of return Rs 4 Rs 2.50 16% 18%

Solution:
Valuation of share under Walters model: P = [D+{Ra(E-D)/Rc}]/Rc =2.50 + 0.18*(4 - 2.50)/0.16 = Rs 26.17

Modigliani and Millers Dividend Irrelevancy Model

P0 = (D1+P1)/1+Ke P0= Prevailing market price of the share P1= Market price of the share at the end of one year D1= Dividend to be received at the end of one year Ke= cost of equity capital

 Problem 3: Falcon Tyres Ltd. Has outstanding 1,50,000 equity shares of Rs 10 each selling at Rs 26 per share. The company is expecting to make a net income of Rs 8,40,000 during the year ending on 31st March, 2010. The company is thinking to pay a dividend of Rs 3 per share at the end of current year. The capitalization at end of 31st March, 2010 on the basis of Modigliani and Miller Dividend Irrelevancy Model (a) If the dividend is paid, and (b) If the dividend in not paid.

Solution: Price of the share if dividend is paid

Price of the share if dividend is not paid

26 = (0 + P1)/(1+0.16) 26 (1.16) = 0 + P1 or P1 = 30.16

26 = (3+P1)/(1+0.16) 26 (1.16) = 3 + P1 or P1 = 30.16 3 = Rs 27.16

Capital Asset Pricing Model

E(Ri)= Rf+i (Rm-Rf) Where,
E(Ri) = Expected rate of return on individual security or portfolio of investments Rf = Risk free return Rm = Expected rate of return on market portfolio (Rm-Rf) = Risk Premium i = Beta of investment i.e. market sensitivity index of a security or portfolio of securities

 Problem 4: ABC Ltd. Is intending to acquire substantial shares in Z Ltd. To acquire control in the company. The beta factor of Z Ltds shares is 1.60 and its current market price is Rs 190 and the company is consistently paying a dividend or Rs 46 p.a.. The risk free market rate of interest is 12% and the rate of return expected on such securities in the market is 18%. You are required to value the share of Z Ltd. Solution

Valuation of share under CAPM

E(Ri)= Rf+i (Rm-Rf) E(Ri)= 12 + 1.6 (18 12) = 12 x 1.6 (6) = 12+9.6% = 21.6%

Dividend Yield
= Annual Dividend / Expected return = Rs 46 / 0.216 = Rs 213