Cost of Capital

Question 1

Why does money have time value?

Answer 1

potential for earning interest/cost of finance
impact of inflation
effect of risk.

Question 2

What is cost of equity?

Answer 2

The rate of return that ordinary shareholders expect to receive on their investment.
Calculated using dividend valuation model.

Question 3

What is the dividend valuation model?

Answer 3

states that the value of a share can be estimated as the present value of future dividends discounted at the shareholders’ required return.

𝑷_𝑶= 𝒅/𝑲𝒆 therefore𝑲𝒆= 𝒅/𝑷𝑶
𝐾_𝑒 =cost of equity
d=constant dividend
𝑃_𝑜=ex div mkt price of share

Question 4

What is Ex div?

Answer 4

share price just after paying dividend

Question 5

What is Cum div?

Answer 5

= share price just before paying dividend

Question 6

What is ex div share price?

Answer 6

Cum div share price- dividend due

Question 7

How to calculate the value of a stock?

Answer 7

= EDPS / (CCE−DGR)
where:
EDPS=expected value of next year’s dividend per share
CCE=cost of capital equity
DGR=dividend growth rate

Question 8

Share price =

Answer 8

PV of growing dividends
P0= D0(1 + g) / (ke- g)
D0= current level of dividend
𝐷_1= Dividend to be paid in one year’s time.
P0= current share price
g = estimated growth rate in dividends
Therefore:
Ke = “D0 (1+g)” /”P0” + g OR Ke = 𝑫_𝟏/”P0” + g

Question 9

What are the two methods of estimating growth?

Answer 9

The averaging method
Growth model based on profit retention

Question 10

What is the calculation for the averaging method?

Answer 10

Averaging method (historical method):
g = n√(𝑑𝑜/𝑑𝑛 ) - 1

𝑑_𝑜 = current dividend
𝑑_𝑛 = dividend n years ago

Question 11

What is the calculation for the Growth model based on profit retention?

Answer 11

g = r x b

g = dividend growth rate
r = % return that the company receives from investments
B = proportion of profit retained (not distributed as dividends.

Question 12

What are the weaknesses of the DVM?

Answer 12

Current market price- subject to other short-term influences, such as rumoured takeover bids
Future dividends- no growth or constant growth assumption not realistic.
growth estimates based on the past not useful; market trends, economic conditions, inflation relevant
Earnings do not feature in the DVM but are an indicator of the company’s long-term ability to pay dividends

Question 13

How do you calculate the cost of preference shares?

Answer 13

𝑲𝒑= 𝒅/𝑷_𝑶
d=constant dividend
𝑷_𝑶= ex div mkt value of share
〖 𝑲〗_𝒑= cost of preference