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With regard to past paper June 2011, Question 1, the answer provided by ACCA –
Extract from Appendix
(a) Fodder Co cash flow and value computation:PV (after 4 years) [4,443 x 1.03/(0.13-0.03)] x [1/(1.13^4)]
i. Is the 0.13 represents cost of capital?
ii. Is the 0.03 represents the growth rate after four years?Basically I do not understand the rationale/assumption for the discount rate applied.
(b) Combined Company: Cost of capital calculation
Ke = 4.5% + 1.46 x 6% = 13.26%
Is the 6% represents sales revenue growth rate? May I know the rationale behind?
Kindly advise the (a) and (b) above.
Many thanks!
(a) The cost of capital is 13% (the workings are in the answer) and this is the discount rate.
However, after 4 years we have the content growth in perpetuity and so we use the dividend growth formula from the formula sheet. (You can use the same formula to get the present value of any growing perpetuity)
Because, however, the growth does not start for 4 years, the answer we get is 4 years into the future and so to get a present value now we need to then discount the answer by 4 years at the cost of capital of 13%.(b) No – 6% has nothing to do with sales revenue!
The cost of equity is calculated using the CAPM formula – Rf + B(Rm – Rf)
The risk free rare is 4.5% (from the question) and Rm – Rf is 6% (the market risk premium)
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