10. Cost of Capital

Question 1

Outline the creditor hierarchy.

Answer 1

On liquidation, the following is the priority of creditors for repayments:

1. Secured creditors including secured bank loans and loan notes.
2. Unsecured creditors including trade creditors and unsecured loans.
3. Preferred shares
4. Ordinary shares

Question 2

What is the formula for share valuation when a company pays constant dividends? What is the formula if the dividend is assumed to continuity to infinity?

Answer 2

Ex-div market value at time 0 = PV of the future dividends at the shareholder’s RRR.

The model for this is:

P₀ = [D₁/(1+r_e)] + … + [D_n/(1+r_e)ⁿ]

Where:

P₀ = current ex-div MV
D_n = dividend at time n
r_e = shareholder’s RRR

If the dividend is assumed to be constant to infinity then, the formula becomes the PV of a perpetuity:

P₀ = D/(1+r_e)

Question 3

What is the formula for share valuation when dividends are forecasted to grow at a constant rate in perpetuity ?

Answer 3

P₀ = {[D₀(1+g)]/(r_e-g)} = [D₁/(r_e-g)]

Where:

D₀ = most recent div.
D₁ = div. in one year
r_e = shareholder’s RRR

Question 4

What are the underlying assumptions of the Dividend Valuation Model (DVM)?

Answer 4

1. All investors have the same expectations and therefore the same RRR.
2. Perfect capital market assumptions:
   - rational investors
   - no taxes or transaction costs
   - large number of buyers and sellers of shares.
   - no individual can affect the share price
   - perfect info is freely available to all investors
3. Dividends are paid just once a year and one year apart.
4. Dividends are either constant or are growing at a constant rate.

Question 5

Outline five advantages of the DVM.

Answer 5

1. It is easy to understand and can be applied to any share that offers a dividend.
2. For minority shareholders who have no control over a company’s policies, dividends are the only available metric.
3. The model is not subjective (eg there’s no ambiguity in determining amounts of dividends whereas earnings or profit are open to interpretation).
4. It is particularly suitable for mature companies paying regular dividends.
5. It is based solely on dividends, taking no account of market conditions, making comparisons across companies of different sizes and industries easier.

Question 6

Outline 7 disadvantages of the dividend valuation model.

Answer 6

1. It cannot be applied to shares that do not pay dividends and therefore cannot be used for smaller business and startups.
2. It assumes shares have no issue costs.
3. It does not explicitly incorporate risk.
4. It is overly simplistic, eg, g can only be an approximation because dividends do not grow at a constant rate in reality.
5. It makes no allowance for non-dividend factors that influence the value of a share (eg brand loyalty and other internally generated intangible assets).
6. It makes no allowance for the effect of taxation.
7. It ignores capital gains tax on investors (although it could be argued that the change in ownership of a share does not affect the PV of a dividend stream).

Question 7

What is the formula for the cost of equity for a company with a constant annual dividend?

Answer 7

It is the dividend divided by the ex-dividend share price (ie the dividend yield).

r_e= k_e =D/P₀

Question 8

What is the formula for the cost of equity given constant growth?

Answer 8

K_e= dividend yield + estimated growth rate.

K_e = r_e = [D₀(1+g)/P₀] + g

Question 9

What are the two methods of estimating the growth rate of dividends? Outline them

Answer 9

1. Extrapolation of past dividends
   - Uses historical growth to predict future growth.
   - Use geometric mean when there’s uneven but steady growth.
   - Do not use when there’s no pattern.
2. Gordon’s growth model
   - Growth is achieved by retention and reinvestment of profits.
   g = br
   Where:
   b = proportion of profits retained (retention ratio)
   r = rate of return on those retained profits (ROCE)

Take an avg of r and b over the preceding years to estimate future growth.

r_e = PAT/net assets
b = retained profit/PAT
r