The market uses dividend valuation model

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Reference no: EM131891952

St James’ Ltd. Has just paid a dividend of £0.22 per share. The market expects this dividend to grow constantly in each future year at the rate of 7% p.a. The cost of capital for St James’ Ltd. is currently 9%. As soon as the dividend was paid, however, the Board of St James’ Ltd. decided to finance a new project by retaining the next three annual dividend payments. The project is seen by the market to be of riskier than existing projects and the cost of capital is estimated to be 10%. It is expected that the dividend declared at the end of the fourth year from now will be £0.35 per share and will grow at the rate of 8% p.a. from then on. You hold 1,000 shares in St James’ Ltd. and your personal circumstances require that you receive at least £200 each year from this investment.

(i) Assuming that there is a perfect market in St James’ Ltd's shares, and that the market uses a dividend valuation model, show how the market value of the shares has been affected by the Board's decision.

(ii) Show how you can still achieve your desired consumption pattern in the first three years while improving your expected dividend stream from then on.

(iii) What would be the Board's decision if the dividend payment was expected increase to only 25p per share? Explain why you came to this conclusion.

(iv) Briefly comment on the limitations of this approach to share valuation. To what extent do you agree with the view that 'valuation is as much an art as a science'?

Reference no: EM131891952

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