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Question 3a ii, b

Recent financial information relating to Close Co, a stock market listed company, is as follows.

$m
profit after tax (earnings) 66.6
dividends 40.0
statement of financial position information
$m $m
non current assets 595
current assets 125
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total assets 720
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current liabilities 70
equity
ordinary shares ($1 nominal) 80
reserves 410
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490
non current liabilities
6% bank loan 40
8% bonds ($100 nominal) 120
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160
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720
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Financial analysts have forecast that the dividends of Close Co will grow in the future at a rate of 4% per year. This is slightly less than the forecast growth rate of the profit after tax (earnings) of the company, which is 5% per year.

The finance director of Close Co thinks that, considering the risk associated with expected earnings growth, an earnings yield of 11% per year can be used for valuation purposes.

Close Co has a cost of equity of 10% per year and a before-tax cost of debt of 7% per year. The 8% bonds will be redeemed at nominal value in six years’ time. Close Co pays tax at an annual rate of 30% per year and the ex-dividend share price of the company is $8·50 per share.

Required:

(a) Calculate the value of Close Co using the dividend growth model

(b) Discuss the weaknesses of the dividend growth model as a way of valuing a company and its shares.