The current market price for shares in company ABC is 550 pence. Spot rates from

Question

The current market price for shares in company ABC is 550 pence. Spot rates from the yield curve for year i are: r1 = 0.04 (4%); r2 = 0.05 (5%) rj = 0.06 (6%) (for j > 2) and the market risk premium (rp) on ABC shares is 4% (0.04) over the risk-free rate. Current dividends are 12 pence per share and at the end of years 1, 2 and 3 are expected to be 10 pence, 12 pence and 14 pence. If dividends are expected to grow at 5% per annum after year 3:, a. Calculate the fair value for the share b. Would you advise an investor to buy the share

Explanation / Answer

a. Calculate the fair value for the share

Rate of return for ABC share Year 1 = 4%+4% = 8%

Rate of return for ABC share Year 2 = 5%+4% = 9%

Rate of return for ABC share Year 3 & thereon= 6%+4% = 10%

Fair value for the share = 10/(1+8%) + 12/((1+8%)*(1+9%)) + 14/((1+8%)*(1+9%)*(1+10%)) + (14*1.05/(10%-5%))/((1+8%)*(1+9%)*(1+10%))

Fair value for the share = 257.31 pence

b. Would you advise an investor to buy the share

No , it would not be advisable an investor to buy the share at 550 pence, Investor should go for short positioning.

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