FINM7006: Applied Foundations of Finance
Tutorial 2 Solutions
Question One
Describe the characteristics of a corporation that differentiate it from other forms of
business organization such as partnerships and sole proprietorships?
The corporation differs from other forms of business organization in three main ways,
namely:
Ownership is usually more widely dispersed: Not only is ownership dispersed,
shareholdings are freely transferable between different shareholders and this
can be done without interfering with the operation of the corporation itself;
Shareholders have no right to participate in the daily running of the
corporation in which they hold shares: The objectives of a corporation are
determined by its board of directors. However, the board itself is elected / re-
elected by the shareholders and the board must report to the shareholders
regarding the operations of / decisions made regarding the company; and,
The liability of shareholders for debts incurred by the corporation is usually
“limited”: This concept and its implication for shareholders is discussed in
detail in the solution to Question Two.
Question Two
What is meant if a shareholder has limited liability? How does this differ from a
situation where a shareholder has no liability?
The liability of shareholders in limited liability corporations is limited to the amount
unpaid, if any, on their shares. Hence, the total loss for shareholders (in the event of
bankruptcy) would be equal to the amount that was paid initially plus any unpaid
(outstanding) component of the share. In contrast, the loss for shareholders in a no
liability company only extends to the amount they have already paid on shares they
hold (no additional unpaid amounts are required). The difference between the liability
of shareholders in limited versus no liability companies is best illustrated by way of
an example: refer to the example in section 2.1 of lecture 3.
Compare the liability of shareholders in limited and no liability companies with the
owners of sole proprietorships or partnerships. If a sole proprietorship or partnership
fails to meet its obligation to creditors, creditors can dispose of the owners’ personal
assets in order to obtain amounts owning to them.
Question Three
What is the difference between a preference share and an ordinary share?
Ordinary and preference shares are similar insofar as they are both equity securities as
both represent ownership in a corporation. In the case of ordinary shares, the holder
has the right to vote and the right to any dividend declared by the board of directors.
However, ordinary shareholders rank last in the event of liquidation. Preference
shares are given priority over ordinary shares for dividends (fixed) and in the event of
liquidation. However, these shares generally have no voting rights attached to them.
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FINM7006: Applied Foundations of Finance
Question Four
Calculate the price of a preference share paying a dividend of $0.50 p.a. given a
required rate of return of 10% p.a. Assume the company has just paid the last
dividend.
The price of one preference share is calculated as:
Question Five
A company has just paid a dividend of $1.00 per share. Dividends paid by the
company are expected to grow indefinitely at a rate of 9% p.a. Calculate the price of
one share in the company if the required rate of return is 12% p.a.
The price of on share in the company is calculated as:
Question Six
What is the per annum required rate of return on a share whose price is $5 and pays
dividends at a rate of $0.25 p.a.? Assume dividends are paid at exactly 1-year
intervals, dividends are not expected to grow and the company has just paid a
dividend.
The required rate of return per annum on the share is calculated as:
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FINM7006: Applied Foundations of Finance
Question Seven
It is January and you are considering purchasing Marigo Ltd’s ordinary shares at the
current price of $50 per share and then selling them at the end of December just after
the annual dividend (expected to be $6) is paid. How much will the company’s
ordinary share price have to appreciate by the end of December for you to earn your
required rate of return of 15%?
or a share price appreciation of $1.50 per share.
Question Eight
Header Motors just paid a $3.50 ordinary share dividend. If the company’s ordinary
share dividends are expected to have a growth rate of 5% p.a., what is the value of
each ordinary share if ordinary share investors require a 20% rate of return?
Question Nine
The ordinary shares of NCP Ltd just paid a dividend of $1.32 and dividends are
expected to grow at an 8% annual rate for an indefinite number of years.
a) If NCP’s current market price is $23.50, calculate the expected rate of return.
b) If your required rate of return is 10.5%, calculate the value of a share for you.
c) Should you make an investment in NCP Ltd ordinary shares?
a)
b)
c) Yes, the investment should be undertaken, as the expected rate of return
implied by the market price (14.07%) is greater than your required rate of
return (10.5%). Also, your value of the shares ($57.02) exceeds the current
market price ($23.50).
Question Ten
Suppose Acap Corporation will pay a dividend of $2.80 per share at the end of this
year and a dividend of $3 per share next year. You expect Acap’s share price to be
$52 in two years. Assume that Acap’s equity cost of capital is 10%.
a) What price would you be willing to pay for an Acap share today, if you
planned to hold the share for two years?
b) Suppose instead you plan to hold the share for one year. For what price would
you expect to be able to sell an Acap share in one year?
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FINM7006: Applied Foundations of Finance
c) Given your answer to part (b), what price would you be willing to pay for an
Acap share today, if you planned to hold the share for one year? How does
this price compare to your answer in part (a)?
We can use Eq. 7.1 to solve for the beginning price we would pay now (P 0) given our
expectations about dividends ($2.80) and future price ($52.00) and the return we need
to expect to earn to be willing to invest 10%. We can use Eq. 7.1 to solve for the price
for which you would expect to be able to sell an Acap share in one year given our
expectations about dividends ($3.00) next year and future price ($52.00) and the
return we need to expect to earn to be willing to invest 10%. Given the price you
would expect to be able to sell an Acap share for in one year, we can solve for the
price you would be willing to pay for an Acap share today if you planned to hold the
share for only one year using the dividend of $2.80 and the expected return of 10%.
a)
b)
c) P(0) = (2.80 + 50.00) / 1.10 = $48.00
