Q.8. An ordinary share pays annual dividends. A dividend of 25p per share has just been paid. Dividends are expected to grow by 2% next year and by 4% the following year. Thereafter, dividends are expected to grow at 6% per annum compound in perpetuity. (ii) Calculate the present value of the dividend stream described above at a rate of interest 9% p.a. effective from a holding of 100 ordinary shares. My question here is, while calculating the "present value", why we do not consider the dividend payment of 25p, which has just been paid. I mean, we are calculating the P.V right, so wouldn't it be just a perpetuity paid in advance each year.. ???
No. If you're calculating the price after the dividend has just been paid, anyone buying the shares at this point wouldn't receive that dividend - they've just missed it - so they wouldn't add it to the value of the share.
I believe the strict definition of ex-dividend is that the purchaser of the share will not receive the next dividend paid after the transaction has taken place. This is not quite the same as the situation in the question, in which the purchaser does not receive the dividend paid just before the transaction but does receive the next one after the transaction.
But doesn't the fact that the "investor has purchased the security and the dividend has been paid" imply that the "next" dividend has been paid? Regards, Sunil
No. Our hypothetical trader purchases the share just after a dividend has been paid and therefore values the share on the basis of the future payments he receives. Obviously, any dividends that have been paid already will not be received by the trader. An ex-dividend security means that the trader will also not receive the next dividend paid after the transaction. This is not the case in the original question.
Thanks...I was under the impression that the hypothetical trader buys the bond before the dividend is paid out...making it an ex-dividend... Thanks for the explanation....However, in questions like this, where this information has not been provided, do we just go ahead and assume that the trader did not receive the first dividend if it is not specified? Regards, Sunil
All the information is there in the question and it was a lot simpler before you started talking about ex-dividend shares. To begin with let's note that the question says this is an ordinary share, not a bond as you seem to think. Next, the question says, "A dividend of 25p per share has just been paid." So the question explicitly places us at a moment in time just after a dividend has been paid. The question then asks us to calculate the "present value of the dividend stream," i.e. the total discounted value of all future dividend payments. This will naturally include the next dividend, i.e. the next one after the one that's just been paid. So you don't have to make any extra assumptions. Just don't confuse yourself with unnecessary complications, like whether the share is ex-dividend. (It isn't in this case because a trader buying the share at this point in time - remember this is just after a dividend has been paid - would receive all the future dividend payments.)
