In these questions you are asked to consider models of equity
valuation.
a) Consider a firm involved in the production of diesel cars, so
its sales are falling. As a result, the company’s earnings and
dividends are declining at a constant rate of 8% per year. If
the company has just paid a dividend of £6 per share and the
required rate of return of equity is 12%, what is the value of the
firm’s share?
[4 marks]
b)The firm announces that it has found a technology to produce
electric vehicles with high degrees of fuel efficiency. Analysts
are impressed and forecast that the share will hit £30 at the end
of year 5. The route to success is expected to be slow and
dividends are not expected until year 3. In year 3 the dividend
will be 51 pence per share, in year 4 the dividend will be 85 pence
per share, and in year 5 the dividend will rise to £1 per share.
How much would you be willing to pay for the stock if your required
rate of return is 12%
[4 marks]
c) Why would you expect the required rate of return on this firm
to be higher than average?
[2 marks]
