A colleague has been taken ill. Your managing director has asked you to take over from the colleague and to provide urge
Posted: Mon Apr 25, 2022 8:31 am
A colleague has been taken ill. Your managing director has asked
you to take over from the colleague and to provide urgently needed
estimates of the discount rate/cost of capital to be used in
appraising a large new capital investment.
You have been given your colleague’s working notes, which you
believe to be numerically accurate.
Working Notes
Estimates for the next 5 year (annual averages)
Stock market total return on equity
16%
Own company dividend yield
7%
Own company share price rise
14%
Standard deviation of the total stock market return on
equity
10%
Standard deviation of own company total return on equity
20%
Correlation coefficient between total own company return on
equity and total stock
market return on equity
0.7
Correlation coefficient between total returns on the new capital
investment and total
market return on equity
0.5
Growth rate of own company earnings
12%
Growth rate of own company dividends
11%
Growth rate of own company sales
13%
Treasury bill yield
12%
The company’s gearing level (by market values) is 1:2 debt to
equity, and after tax earnings
available to ordinary shareholders in the most recent year were
¢5,400,000 of which
¢2,140,000 was distributed as ordinary dividends.
The company has 10 million issued ordinary shares which are
currently trading on the stock
exchange at ¢3.21 per share. Corporate debt may be assumed to be
risk-free. The company
pays corporate tax at 35%.
REQUIRED:
Estimate the company’s weighted average cost of capital
using:
(i) The dividend valuation model (DVM).
(ii) The capital asset pricing model (CAPM).
(iii) Calculate the cost of capital for the retained
earnings.
you to take over from the colleague and to provide urgently needed
estimates of the discount rate/cost of capital to be used in
appraising a large new capital investment.
You have been given your colleague’s working notes, which you
believe to be numerically accurate.
Working Notes
Estimates for the next 5 year (annual averages)
Stock market total return on equity
16%
Own company dividend yield
7%
Own company share price rise
14%
Standard deviation of the total stock market return on
equity
10%
Standard deviation of own company total return on equity
20%
Correlation coefficient between total own company return on
equity and total stock
market return on equity
0.7
Correlation coefficient between total returns on the new capital
investment and total
market return on equity
0.5
Growth rate of own company earnings
12%
Growth rate of own company dividends
11%
Growth rate of own company sales
13%
Treasury bill yield
12%
The company’s gearing level (by market values) is 1:2 debt to
equity, and after tax earnings
available to ordinary shareholders in the most recent year were
¢5,400,000 of which
¢2,140,000 was distributed as ordinary dividends.
The company has 10 million issued ordinary shares which are
currently trading on the stock
exchange at ¢3.21 per share. Corporate debt may be assumed to be
risk-free. The company
pays corporate tax at 35%.
REQUIRED:
Estimate the company’s weighted average cost of capital
using:
(i) The dividend valuation model (DVM).
(ii) The capital asset pricing model (CAPM).
(iii) Calculate the cost of capital for the retained
earnings.