Comments

  1. avatar says

    Dear John,

    Thank you for another great lecture, I have only 1 query. Regarding the rearranging of the growth model formula to find the shareholders required return, I have been happily rearranging as you instructed when I came across a question in my BPP revision guide that used a different formula. As I don’t expect you to have a copy of the textbook I will rewrite the information that I was given:

    “Ordinary shares are quoted at 80c, assume the market estimate of the next dividend is 4c, growing at 12% p/a indefinitely. There are 10400 shares in issue. What is the cost of capital of these shares (for the purpose of WACC)?”

    I calculated this as I believed correctly using your method as follows:

    Re = 0.04 (1 + 12%) + 12% = 17.6%
    —————–
    0.80

    The answer in the textbook however showed the following:

    Ke = 0.04 + 12% = 17%
    —–
    0.80

    My question to you would be, is there a difference between Re and Ke (as symbols) and am I therefore taking your formula in vain, or is this just another textbook example of the publisher getting the answer wrong?

    If you get chance to reply before my exam on Friday that would be fantastic!

    Many thanks Donna

    • Profile photo of John Moffat says

      It is not because of the symbols!
      Do(1+g) in the formula is the dividend in one years time.
      Since this question says that the next dividend (i.e. the dividend in one years time) will be 4c, then this is equal to Do(1+g)

  2. avatar says

    hi sir I was revising this for p4 in june attempt and in example 1 we got a return of 12.5%. I just want to ask that will we be giving this return on the nominal value or on the market value because if we give this on nominal value the dividend would decrease from 30c to 12.5c?

    • Profile photo of John Moffat says

      The market value of a share is determined by the dividend they expect and the rate of return that they require.

      So the required return (and therefore the cost of equity) is calculated using the expected dividends and the market value (not the nominal value).

      • Profile photo of opktun says

        Hello Mr. Moffat

        Let me start by saying your lectures are great and easy to go through. I don’t get bored. I think I have gone through 30 in 4 days or something! Also, you explain everything very well. You seem to cover every detail yet don’t take long to do so.

        Anyway, I have a similar question to what Uzair asked above. We calculated 12.5% as the cost of equity (thus the estimated shareholders’ required rate of return).

        However, raising money from shareholders in this case is through new issue of shares, isn’t it? So if we do decide to issue new shares, where does the 12.5% come into play?

        Are we promising dividends at 12.5% of our profit after tax (and thus they would be similar to preference shares)?
        I might be overlooking something very obvious but if we estimate that our cost of equity is 12.5%, how are we promising that 12.5% interest to investors each year if we do issue new shares? Will we tell them our estimated future dividends? Will we give them the estimated growth rate of dividends/profits?
        It is easy to understand it in debentures, where we are giving a fixed interest. But how do we pay out a fixed interest on ordinary share capital?

        Or is it just that since we already know the market value, we are working backwards and seeing how much return our existing shareholders are getting on average? (Because the rate of return is already taken into account in determining the market value). I don’t know if I am making any sense!

        Also, if we do indeed issue new shares, do we issue them at the nominal value of $1? Or will we open a share premium of $1.4 per share in addition to the nominal value to match the market price?

        I don’t know how relevant these questions are for the F9 exam, but better to clear them up.

        Thanks for your time.

        Regards

        Omar Parvez

      • Profile photo of John Moffat says

        Shareholders could put their money in the bank and be earning interest, and so will only be prepared to invest money in the company if they expect to get a better return. Investing money could be by buying shares, or allowing the company to retain earnings (which is money to which the shareholders are entitled to).
        They will want a return either by way of dividend or by way of capital growth – either way it means that the company must use their money to get a return at least as high as that required by shareholders.

        The problem is in deciding what return it is that shareholders require.

        The way we attempt to find out is by looking at the market value of the share currently. Since the market value is the present value of expected dividends, we work ‘backwards’ using the dividend growth formula. In theory this is fine, but the problem is that we do not know what dividend growth shareholders are expecting – we are forced to make an estimate which could be wrong.

        The other way (which you will cover in the capital asset pricing model lectures) is to calculate the riskiness of the shares (measured by the beta). Since the return required by shareholders (and therefore the return that the company has to achieve) is determined by the riskiness of the shares, then if we can calculate the beta and therefore the return required.
        Again, there are limitations as to the accuracy, but it is regarded as a better indicator.

        Remember that the company raises money from shareholders not only by issuing shares – retaining earnings is using shareholders money as well.
        If the company does issue shares then they would be extremely unlikely to issue them at nominal value. They would normally issue them at a price that was at least equal to the current market value of existing shares (unless, or course, it was a rights issue). The fact that this would increase the share premium account balance is not relevant – we are not interested in the financial accounts aspect.

  3. Profile photo of sonria says

    Hi Sir,
    Thank you for showing us how to calculate to the fourth root, however you didn’t mention how to calculate to the fifth root if five years is given in the exam. Would it then be a matter of calculating to the third root and then to the second root? Or calculating to the second root first and then the third root second? Or is there another way?
    Thanks for your help and quick response as exam is only 3 weeks away :)
    Sonria.

  4. avatar says

    I enjoyed the session. I am a person who cannot cram things I don’t understand, however if I do understand something I will very rarely every forget it. So to Mr. Moffat, thanks for helping me to understand the formula so that I won’t have to cram it off…

      • avatar says

        Thanks for your reply Mr. Moffat, however I am not getting the same result. I am calculating it as follows: 33000/28000= x2 (the first result I take the square root- 1.3890) = x2 (the second result I take the second square root-1.9294), eventually I am getting 1.9294 as a final result. Thank you very much

      • Profile photo of John Moffat says

        What you are doing is squaring it!

        (1.3890 x 1.3890 = 1.9294)

        I do not have your calculator, but there must be a square root button on it.
        33000/28000 = 1.1786. Square root once gives 1.0856, and square root again gives 1.0419

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