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Hi there,
The digital version of the BPP workbook for FM has the below example for Net operating income approach
A company has $5,000 of debt at 10% interest and earns $5,000 a year before interest is paid.
There are 2,250 issues shares, and the weighted average cost of capital of the company is 20%.The market value of the company should be as follows:
Earnings $5,000
Weighted average cost of capital 0.2Market value of the company
($5,000/0.2) $25.000
Less Market value of debt $5,000
Market value of equity $20,000The cost of equity is therefore (5,000-500)/20,000 = 4,500/20,000 = 22.5%
and the Market value per share is [(4,500/2,250) * (1/0.225)] = $8.89Can you tell me where the formulas to calculate the cost of equity and the market value per share above are coming from please?
Thanks
ElizaWithout further information we have no choice but to assume that the company is distributing all its earnings as dividend and that therefore there is no growth in dividends.
As I explain in my free lectures, the market value of equity is the PV of future dividends discounted at the shareholders required rate of return.
With a constant dividend in perpetuity, the discount factor is 1/r where r is the discount rate.The dividend = 5.000 – 500 = 4,500.
Therefore 4,500 x 1/r = 20,000
So the shareholders required rate of return = cost of equity = r = 4,500/20,000 = 22.5%Given that the total MV of equity is $20,000, and there are 2,250 shares in issue, the MV per share is 20,000/2,250 = $8.89
All of this is explained in my free lectures. The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
Hi John,
Thank you so much for that it makes sense now.
I do watch your lectures and I will go back and revisit that topic.
Thanks again 🙂
Eliza
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