Question

QUESTION TWO It is commonly accepted that a crucial factor in the financial decisions of a company, including the evaluation of capital investment proposals, is the cost of capital. Required: (a) Explain in simple terms what is meant by the 'cost of equity capital for a particular company (5 marks) (b) Calculate the cost of equity capital for Genesis PLC from the data given below, using two alternative methods, i.e. (i) A dividend growth model (ii) The Capital Asset Pricing Model. Genesis PLC Data: Current price of stock on stock exchange Current annual gross dividend per share Expected average annual growth rate of dividends Beta coefficient for Genesis PLC shares Expected rate of return on Treasury Securities Expected return on the market portfolio K1.20 КО.10 7% 0.5 8% 12% (10 marks) (c) State separately, for each model the main simplifying assumptions made and express your opinion whether, in view of these assumptions, the models yield results that can be used safely in practice. (10 marks) Total (25 marks)

Answer 1

Answer a:
Cost of equity capital is the minimum rate of return that a company shall maintain. It must
maintain it so as to maintain the current market price of the equity. It is a required rate of
return that a company earns on the equity invested in the company. There are various ways
of calculating it such as CAPM, PE Ratio, Gordon's Growth Model etc.
The investors need assurance of the cost of equity capital so as to benefit the return reward
on the amount of the capital invested by them.
Answer b:
(i) Dividend growth model
P = [D (1 +g)] / ke - g
where,
P = Current Market Price of share
D = Current dividend of share
g = growth rate
ke = Cost of equity capital
1.20 = [0.10 (1+0.07)] / (ke - 0.07)
ke = 15.92%
Cost of equity capital is 15.92%
(ii) Capital Asset Pricing Model
ke = Rf + B (Rm - Rf)
where,
ke = Cost of equity capital
Rf = Risk-free rate (return on treasury securities)
Rm = Market portfolio return
B = beta
ke = 8 + 0.5 (12 - 8)
ke = 10%
Cost of equity capital is 10%
Answer c:
Assumptions of Dividend Growth Model:
1. The dividend growth will be constant.
2. Company's business model is stable.
3. Company has stable financial leverage.
4. Company's free cahs flow is paid as dividend.
Assumptions of Capital Asset Pricing Model
1. All investors are averse to risk.
2. Markets are highly efficient.
3. The only coefficient of risk is the beta risk.
4. The assets are fixed at any given point of time.
5. There are no taxes, no inflation, no transaction fee etc.