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SOUD SAEED says

Hi Mr Moffat,,just wanted small clarification,,if in a certain scenario we were given both return on capital employed or return on equity,,which one should we use in relation to Gordons growth model?

johnmoffat says

This is rather hypothetical – the examiner has never given both for these purposes!

(In fact I can only remember two times – both of them a very long time ago – when Gordons growth model was even relevant!)

However, what we need is the rate of return that the company gets on reinvestment. In theory it would be the return on equity, but if he did give both then you would get credit for using either (provided you stated your assumption).

SOUD SAEED says

Really appreciate it, you have cleared my doubts.

massivecodedake says

Hi,John.In example 6 question C , Shouldn’t the answer to be 280(1.0675)^3?According to the share price with constant growth rate model,the numerator should be D0(1+g) and I think D0 is 20(1.0675)^2 so D1is 20(1.0675)^3.Therefore the price in 2 years time should be 280(1.0675)^3.Is it my opinion correct? Thanks

johnmoffat says

No – the answer in the notes and the lecture is correct. The share price will be 280 (.0675)^2

Although the numerator will indeed be 20(1.0675)^3, you are forgetting that the numerator for the current share price will be 20(1.0675). So…..the numerator will be (1.0675)^2 times the current numerator.

Always (in theory) the share price will increase at the same growth rate p.a. as the dividend growth rate.

davisyieh says

Sir John, for part b, why is the cost of capital not the return of 18% in the question? Isn’t required rate of return = cost of capital?

johnmoffat says

I assume you are meaning part (b) of example 6.

Here, the shareholders are requiring a return of 14.375% (as calculated in part (b) – this is why they are prepared to pay $2.80 per share on the stock exchange). As a result the company needs to give them 14.375% and so the cost of equity is 14.375% (and here also the cost of the capital is 14.375% because there is no debt borrowing – this is dealt with in the next lecture).

The company therefore needs to make sure that they invest the money to get a return of at least 14.375% – if they can earn more then great, if they earn less from any investment then they should not invest.

In this case they are earning 18% from investing the money which is great.

(In the long term it is the case that if the company is always managing to earn 18% on investments, then shareholders will eventually want a return of 18% themselves (this is due to risk and is covered in a later chapter), but from year to year this certainly need not be the case.)

I hope that makes some sense

davisyieh says

Oh thank you very much! This really help! Your explanation is great, thanks Sir John.

morren says

Hi John:

Could you kindly clarify how you apply “before and after taxes”.

Do appreciate

johnmoffat says

You will have to be a bit more specific as to what you mean.

For cost of capital we always want the cost to the company. Because debt interest is tax allowable, the cost to the company is the cost after tax relief (so we take the after tax interest when calculating the cost of debt).

morren says

Hi John:

I have a much better understanding of “after-tax” cost of capital now.

Can you clarify a few things for me;-

1. how do you calculate the cost of preference share, dec. 2010 question # 4c? I’m not sure if I grasp the concept from the answer.

2. Dec 2012 # 2a, is it a error that current receivables days should be 60 and not 30?

3. Dec 2012 # 2b, i note in the answer the holding cost was not discounted. why wasn’t it?

4. Dec 2009 # 1a, (ASOP Co) tax benefit was applied to the licencing fee. Why so? The question asked for “financing” cash flow, what is different about a financing cash flow?

Thank you

johnmoffat says

The cost of preference share is simply the dividend/market value. They pay a constant dividend, and there is no tax relief on the dividends. The dividend is quoted as a percentage of the nominal value.

The answer does not mention the current receivables days. It is not necessary to calculate them because we know what current receivables are from the balance sheet. (our current terms of sales are payment within 30 days, but that does not mean that everyone does pay within 30 days.)

We never discount the holding cost in the exam. (Maybe in real life, we should, but it would be a big problem because the cost is spread day-by-day over the year and we normally only discount for whole years.)

It is reasonable to assume (from F6) that the licencing fee is tax allowable. The reason it is needed when we are considering the cost of financing, is that although it is not relevant if we lease, it is relevant if we buy. So if we are comparing the cost of leasing with that of buying we need to take it into account.

morren says

from the info provided the examiner said we should “assume” 60 days ……. Earlier when I downloaded the examiners reports, Dec 2012 was not accessible.

Thanks again

afridi420 says

sir i didnt get example 6 part c in chapter 17

manisha says

The market value increases at the same rate dividend increases.(refer to the eg on pg94).

In part a, you had calculated it and its 6.75%. Hence,

market value of share in 2yrs time

= 2.80(1+0.0675)^2

=$3.19

munthaliaunward says

both comments are right but i see the driving factor is the interet rate because this seems to be the determing factor in the sense that an increase in interest rate will automatically increase SH/H reguired return but a decrease will also decrease share holders return though a decrease is more demotivating to investors, since they expect their money to be worthy investing hence will bring conflict here.

johnmoffat says

Thank you for your comments.

You are quit right – in practice the growth in the share price is unlikely to be the same as the dividend growth rate,

The main reason for this is that the shareholders required rate of return is likely to change – partly because general interest rates change (if interest rates in general go up then shareholders will require a higher rate of return, and vice versa), and also because the riskiness of the business might change (if the company becomes more risky then shareholders required rate of return will increase, and vice versa).

However, if we are trying to predict the future share price, then we cannot predict what will happen to the interest rates or to the riskiness and therefore all we can do is assume that the remain the same – in which case the share price should increase at the same rate as the growth in dividends.

funlover says

Absolutely awesome.

By the way, to answer to the 6 c I have actually used the modified version of dividend growth model.

ie if p0 = d0(1+g)/ Ke – g , then p2 should be equal to d2(1+g)/Ke-g OR the same as saying p2= d3/Ke-g.

As d3 is equal to d0(1+g)^3, we can get the answer to p2 which is the market value of share in two years time.

But your explanation about market value is the present value of future dividends discounted at shareholder’s expected return and if dividends are growing at a certain growth rate and the market value should be growing at the same growth rate, says it all.

But in practise, I believe market value and dividends are not growing exactly at the same growth rate.

Can I please have your comments about this Mr John.