Expected Return (Ch 22)

[act_stu]

In chapter 22 we see that the
Expected return = initial income yield + expected capital growth

So, suppose the share price of company A is x pence.
The last dividend just paid was y pence and the dividends are expected to grow by 5% each year - so next year the dividend paid out will be y*(1+5%) and the year after it will be y*(1+5%)^2 and so on.

My (probably silly) questions are:
1. Is it right that the dividend yield will be 5% in this case, i.e. dividend yield = growth rate of dividends?

2. Out of interest (I don't think it would be required for CA1), how is future dividend yield determined? Would it involve stochastically projecting profits of the company and then working out the dividends that could be given and so arriving at dividend yields?

3. Formula on page 6 says, price = dividend/ dividend yield.
So, am I correct in saying that the share price in my example is

x = y*(1+5%)/5% ? {I believe this is covered in another chapter}

4. What is meant by initial yield on an asset? How would I calculate the initial yield in this example?

Cheers

 

[Lynn Birchall]

Hi

dividend yield = amount of dividend / share price

Prospectice dividend yields are often used - this means that the amount of dividend used in the calculation would be the dividend expected to be paid in one year's time.

So, using the terms you've defined,

prospective dividend yield = y (1+5%) / x

So, the formula on page 6 that you mention is a rearrangement of the dividend yield definition. So, in your example,

share price x = y (1+5%) / prospective dividend yield as above

Initial yield is I think sometimes used by as an alternative name for the "income yield". Income yield is the initial amount of income an investor receives from an asset / asset price. So, for a share, the income yield is the dividend yield. For a property, the income yield is the rental yield (=amount of rent / property value).

 

[act_stu]

Hi Lynn - thank you for the explanation. It was certainly helpful.

I had another question - this time on share price volatility.
I think I read somewhere in the course notes that gearing increases share price volatility or volatility of profits (or both, not sure ).
1. We know that the share price is the PV of all future expected dividends.
2. Dividends are related to the profits of the company.
3. Profits are related to the riskiness of the projects undertaken by the company.
Now, if a company is highly geared
For example: 80% bonds (debt) and 20% equity where
bondholders receive fixed coupon every 6 months and
equityholders receive a dividend (if the co makes profit).
Since the company is highly geared, it has a greater commitment to make the fixed coupon payments and so would take less risky projects - and make less profit but the profits would be more stable. So, dividends would be more stable (although smaller since a less risky project was undertaken).
Is my understanding here correct?

 

[Anna Bishop]

Hello

The gearing implies volatility argument can be illustrated with some simple accounts. Here are some basic accounts for a company that sells widgets. We assume for now that it only incurs variable expenses. The company has issued debt of 100 and hence is geared. It pays "fixed" interest on that debt of 10% pa.

Sales = 100
Expenses = 20
Interest paid = 10
Profit before tax = 70

Now suppose that we are in a bull market and that, next year, sales are fantastic. The accounts for next year are as follows:

Sales = 200
Expenses = 40
Interest paid = 10
Profit before tax = 150

Notice how, although sales have doubled relative to the first year, profits have "more than doubled".

The year after, a bear market hits and things aren't so good. The accounts for that year are as follows.

Sales = 50
Expenses = 10
Interest paid = 10
Profit before tax = 30

Notice how, although sales have halved relative to the first year, profits have "more than halved".

So we can see that the effect of "financial gearing" is to increase the volatility of profits to shareholders. This is because of the fixed nature of the payment.

Gearing can have a positive effect in a bull market but is a worrying strategy in a bear market.

A similar effect would occur if there were some fixed expenses, rather than just variable expenses. This is called "operational gearing".

As to whether a company, which is geared, would take on less risky projects as a result, I'm not so sure! One could argue it the other way - it has geared (ie borrowed) in order to take on risky projects.

I hope this example works for you!
Anna