Cost of Equity Flashcards
What do shareholders expect for a dividend be paid?
At least once at the end of the year
Continuous growth
What if expected return is not achieved by the firm?
Share price falls which damages shareholder’s wealth
Weaknesses in dividend growth model?
Dividends are paid
Company has share price
Dividend growth is estimated and is constant
What is meant by cum div?
Dividend is about to be paid
When should the share price need to be adjusted?
By stripping the dividend out of the share price to create an ex-div price
Why is the ex-div price needed?
As shareholders real investment is not cum div price if they get a dividend
If the share price is ex-div?
There is no imminent dividend and therefore the adjustment does not need to be made
Methods of estimating future dividend growth?
Using historic growth
Using current reinvestment levels
What is another method of calculating cost of equity?
CAPM
Assumption of CAPM?
Investors diversify their investments across a wide portfolio to reduce risk
Number of investments = less risk?
yes
What is unsystematic risk?
Component of risk associated with investing in a particular company
What is systematic risk?
Component of risk that still remains even of a diverisifed portfolio is created
What is a diverisifed investor only concerned with?
Systematic risk
Why is beta factor important?
As some firm’s shares are more sensitive to market downturns than others are
Beta < 1?
Below average risk. Returns expected by shareholder less than market average
Beta = 1?
Moves in line with market. Returns expected by shareholder equal to market average
Beta > 1?
Above average risk. Returns expected by shareholder are greater than market average
What is the difference between expected average market return and risk-free return?
Market or equity risk premium
What is a risk-free investment?
Treasury bills
Drawbacks of CAPM
Single period model
Estimating beta factor
Size of company
Assumes diversified portfolio
Why is a single period model a disadvantage?
Does not adjust for different planning horizons
Why is estimating the beta factor a disadvantage?
Historic and does not give accurate measure of risk
Why is size of company a disadvantage?
Small companies
What happens with shares with book values that are close to their market values?
More likely to fail
Why is CAPM greater tha dividend growth model?
It does not rely on potentially inaccurate estimates of future dividend growth rate
