Hi, guys.
Been given a class exercise on The Discounted Dividend model, and i cant get my head around it! I understand the basic idea of the Growth equation, but in this example cannot understand what variables go where?
Suppose an IT firm Banana Computer has announced that it has agreed to sell off
its software business to a major software company WivSoft at
£0.2 billion. The
announcement came as a complete surprise to the market.
Prior to the announcement, Banana Computer’s market capitalisation is at £1.5
billion, and it has just paid out an aggregate cash dividend of £50 million, while
the dividend is expected to grow at 5% every year (you may use this number in the
discount dividend model). In the announcement, Banana Computer explained that
it would use the £0.2 billion (from the sales of its software business) to invest in its
hardware business, and now the market expects the dividend would grow at 7% every
year. However, the market capitalisation of Banana Computer remained unchanged
at £1.5 billion upon the announcement.
On the other hand, WivSoft’s market capitalisation stood at £1.2 billion prior
to the announcement, and it has also just paid out an aggregate cash dividend of
1
£
40 million, while its dividend is expected to grow at 10% every year prior to the
announcement. Upon the announcement, the market capitalisation of WivSoft has
become £1.3 billion, and the risk adjusted discount rate for WivSoft’s shares has become
15%. Assuming that the discounted dividend model holds, answer the following
questions.
(a)
What is the risk adjusted discount rate for Banana Computer’s shares prior to
the announcement? How about after the announcement? How about WivSoft’s prior
to the announcement?
(b) What should be the expected dividend growth rate of WivSoft after the announcement?
(c)
What can we say about the market’s evaluation about the announcement?
Any help would be appreciated.. Dont worry if not, its only a class exercise and was only for the benefit of me understanding it.
Discounted Dividend Model
