Summary
Highlights
The lecture introduces the concept of the cost of capital, which is essential for appraising new investments. It emphasizes that this topic is frequently tested in exams. The cost of capital relates to the cost of financing for a company, sourced through either equity (shares or retained earnings) or long-term debt. This particular lecture focuses on calculating the cost of equity finance, revisiting concepts from earlier financial management exams.
There are two main ways to calculate the cost of equity, depending on the available information. The first method, for situations with a constant dividend, involves using the market value of shares and expected dividends. Shareholders determine market value, which is the present value of future expected dividends, discounted at their required rate of return. For a constant dividend perpetuity, the formula simplifies to Market Value = Dividend / Required Rate of Return, allowing calculation of the required return (Ke).
Typically, shareholders expect dividends to grow. The Dividend Growth Model (Gordon Growth Model) is used in such cases. The formula provided in exams is: Ke = [D0 * (1 + G) / P0] + G, where D0 is the current dividend, G is the dividend growth rate, and P0 is the market value per share. The market value (P0) should always be the ex-dividend (ex-div) market value, meaning after a dividend has been paid. If a cum-dividend (cum-div) value is given (i.e., dividend about to be paid), the dividend must be subtracted from the market value to arrive at the ex-div value.
When the dividend growth rate (G) is not directly provided, it must be estimated. One method is to calculate the average historical growth rate from past dividends. This is done by taking the earliest dividend, multiplying it by (1 + G) raised to the power of the number of growth periods, and equating it to the latest dividend. For example, if there are four years of growth, Earliest Dividend * (1 + G)^4 = Latest Dividend. This requires a scientific calculator to find the root of the ratio.
Another method to estimate the dividend growth rate is using the 'g=rb' formula, where 'r' is the return on investment and 'b' is the proportion of earnings retained. Dividends grow if earnings grow, which typically happens through reinvesting retained earnings. The more a company retains and reinvests, and the higher the return on these investments, the faster earnings and thus dividends will grow. 'b' is calculated as the retained earnings divided by total earnings (1 - dividend payout ratio).
The lecture provides examples demonstrating how to apply the 'g=rb' formula to estimate the dividend growth rate and subsequently use it in the cost of equity formula. It also shows how to estimate the future market value of a share. The market value of a share is expected to grow at the same rate as dividends, so to find the market value in future years, the current market value is multiplied by (1 + G) raised to the power of the number of years.
The lecture concludes by reiterating that the covered topics on the cost of equity should be a revision for many. It mentions that there is an alternative and more common way to determine the required return for shareholders and thus the cost of equity: the Capital Asset Pricing Model (CAPM), which will be discussed in a later chapter. The next lecture will focus on calculating the cost of debt.