ACCA F9 - Dividends

mark057 · August 2013

Hi

Can anyone explain in simple terms what a dividend stream is?

I have a case study in my book and it says a firm pays 10 cents in perpetuity, the cost of equity is 10%.

It then says the dividend stream is calculated by:

10/0.10 = 100 cents.

What does that 100 cents represent??? I just don't understand.

Any help would be gratefully received.

Mark

SandyHood · August 2013

10 c represents the annual dividend per share
0.1 is the cost of equity(10%)
so the value of a share (using the dividend valuation method) is
annual dividend = 100 c
cost of equity

Dividend stream refers to the continuing payment of a dividend (in this case) of 10 c per share.
And the value of this stream is (at its present value) 100 c.

Perpetuity is - forever into the future

mark057 · August 2013

Hi Sandy,

Yes, I understand that but does that mean each shareholder receives 100c per share in dividend? Or
does it mean there shareholding is worth 100C per share and they receive 10c or 10% of that overall
share value in dividends?

Thanks

Mark

KernowAccountant · August 2013

mark057 wrote: »

Hi Sandy,

Yes, I understand that but does that mean each shareholder receives 100c per share in dividend? Or
does it mean there shareholding is worth 100C per share and they receive 10c or 10% of that overall
share value in dividends?

Thanks

Mark

Neither.

100c is the present value of the total future cashflows i.e. the 10c dividend in perpetuity.

SandyHood · August 2013

KernowAccountant is correct.

The dividend the shareholder receives is 10 c every year.
This income stream is worth 100 c now

So the theoretical value of a share now is 100 c

mark057 · August 2013

I been reading some more of my F9 book and think I'm starting to see what you mean regarding the dividend stream, so
many thanks for the help!

Just one more query relating to the Internal Rate of Return. I don't really understand what it means or how to use when
making an investment decision.

Any ideas?

Mark

SandyHood · August 2013

IRR is the discount rate that will give a net present value of a project as 0.

I guess that you understand that as interest (or discount) rates increase, fewer firms are willing to invest. In financial terms, the higher the discount rate the harder it becomes to make a positive NPV. At a specific discount rate the NPV will be zero, that point is called the Internal Rate of Return (it is the % return that the project will generate).
Businesses often have hurdle rates that they set for projects. These are the minimum IRRs acceptable for investment money to be made available.
If a project has an IRR above the company's hurdle rate then it is worth looking at as a potential investment.

The Lex column in the FT occassionally highlights real life company hurdle rates.

mark057 · August 2013

Thanks for that Sandy. I fully understand what you are saying there.

I've also had a question from the perspective of an investor who loans money and calculating IRR.

In the question the investor lends $100.00 on a 12% redeemable loan over 5 years.

Once the interpolation is calculated between a DF of 5% and 15% the required return of the investor is calculated
at 10.68%. Obviously I understand what a rate of return is but how does this fit into the context of an investment
decision?

What does the 12% return mean in the context of the 10.68% IRR calculation?

Mark

SandyHood · August 2013

$100.00 on a 12% redeemable loan over 5 years

This means (probably)

The investor buys a bond now
that will pay $12 interest in each of 5 years
and repays $100 at the end of 5 years

The 10.68% is the yield to redemption.

The 12% is a nominal rate which you use to find the annual interest in $s
10.68% is the "return"

Why is is lower than 12%?
My guess is that the market value of a 12% bond is over $100, so the return is lower. If not that, then a similar reason.

As far as the decision to invest/not to invest the investor needs to combine the return of 10.68% AND the level of risk and see whether this fits his/her own attitude to risk and his/her return requirements.

mark057 · August 2013

Thanks for the help Sandy!

So the 10.68% return would be a return on the original value of the loan note (in this case $100.00) or the market value of the loan note?

Sorry to sound obtuse but the book does not explain it very well as usual.

Mark

SandyHood · August 2013

The 10.68% is the return not the market value.

****************************************************
Now, I've looked at your calculation.
If you'd used 12% instead of 5% and 15% I think you'd find a value of NPV = 0
Please just check it.

ACCA F9 - Dividends

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