Question 3

The recent trade war has hit the Orange Company severely. Management announced that previous plans to expand its operations would be cancelled. Orange just paid a dividend of $2.50 but announced that next years dividend would be cut to $2 per share, and only grow at a rate of 2% per year forever. The market price of the stock was $20 before the announcement. The stocks expected return is 15%.

(a)Calculate the price of the stock after the announcement based on the constant dividend growth model. (4 marks)

(b)Explain one (1) limitation of the constant dividend growth model.(3 marks)

(c)Briefly discuss two (2) reasons each for an investor to prefer to invest in the convertible bonds of a company over the companys: (i)Preferred shares(ii)Ordinary shares (8 marks)