The cost of capital (part 1) – ACCA (AFM) lectures
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Sir you mentioned that theoretically market value is the present value of the estimated future cashflows a shareholder expects discounted at the “cost of equity”. So why in example 6 part C, you have not discounted the future dividend cashflows over the cost of equity?
And even if we rearrange the DVM formula for PO, its equivalent to Po = Do/Ke
The MV in 2 years time is the PV of the future dividends at that time (i.e. from time 3 to infinity).
It is simply that since all the future dividends in 2 years time are higher than the future dividends ‘now’ by 2 years growth, the PV of those dividends will automatically be higher that the market value ‘now’ by 2 years growth.
You last sentence is only true if there is no dividend growth.
Greetings Sir,
In example 6c, estimate the market value per share in 2 years time, my calculation shows the answer as $3.93. Please help guide me where I am going wrong.
Warmest Regards,
A Student
Given that the dividends are growing at 6% per year, the market value will also grow at 6% per year.
Given that the current MV is $2.80, then in 2 years time it will be 2.80 x 1.06^2 = 3.15.
Can you please explain what is the difference between (a) and (b) of Example 8? At 27:00 of your lecture, it is mentioned that very rare to ask “(a) return to investors” but usually ask “(b) cost to company” but it seems like there is no difference in question solving between (a) and (b) except for applying tax effect on interest. Or is the tax effect IS the only difference between return to investors and cost to the company? Thank you for your wonderful lecture!
Yes. As far as debt finance is concerned, the only difference is that the company gets tax relief on the debt interest which makes the cost to the company lower.
in ex6 C can we increase the dividend by 6.75% for two years and then discount them at 14.375%? I got 3.16 (after adding initial 2.8) as the MV of share
Although is gives a value close to the correct value, it is just a coincidence. That approach does not work.
Thank you so much for these videos!!
You are welcome 馃檪
Please, help me don’t understand how you arrived at 0.0419 or 4.19%.
I clearly understood other parts
I assume that you are referring to example 4, in which case we take the fourth root of 33,000/28,000 and then subtract 1 from the answer.
( I assume that you have a scientific calculator and know how to calculate a 4th root?)
Hi, would you mind explaining how you got here, please?
Are you meaning the actual calculation of the 4th root of 33,000/28,000 (because I explain why we want it in the lecture)?
It depends on which calculator you are using, but on my calculator you divide 33,000 by 28,000 and then you take it to the power of 0.25 (which is the same as taking the fourth root). Then you subtract 1 from the answer, which gives you 0.0491 (which is the same as 4.91%).
Which book is he referring to when he asks us to look at the examples? Could anyone please help answer this
The free lecture notes that are referred to at the start of every lecture. You can download them by following the link listed at the top of this page!
Great.
Hi John, many thanks for excellent lecture. A question on Example 6 (c)
– you estimated market value per share in 2 years time by growing the price at dividends growth rate, logic is clear (assuming the price will be driven by dividends growth only) = $3.19
I thought I should get the same result if I actually use Ke and G in Growth Model formula (which should be the same), the result is different for some reason: P(2 years) = 20*(1+0.0675)^2 / 0.1438 – 0.0675 = $2.99
Would you have a view on why its different, shouldn’t be different in theory (assuming price is driven by dividends growth only)
Hi there won;t be any difference. You are looking at it right except a little calculation mistake.
The right calculation is, P(2 years from now) = 20*(1+0.0675)^3 / 0.1438 – 0.0675 = $3.19
Reason for using (1.0675)^3 is as below:
In growth model – to calculate market value of today, we use dividend in one year’s time [Do(1+g)], and therefore – to calculate market value in 2 years time, we need to use dividend in 3 year’s time [Do(1+g)^3].
I hope it explains.
That makes so much sense! Thank you so much @shanky95! Really helped as i had a similar doubt as tojik.
Please can you advise why sometimes in Ke=Rf+Be(Rm-rf), Rf is deducted from Rm, sometimes nit. I sm very confused!
Rf is always subtracted from Rm !!!
Rm is the market return. What is confusing you is that Rm – Rf is the market premium, and questions sometimes tell you the market return but sometimes tell you the market premium instead.
I do explain this in the lectures.
Thank you so much for the nice and quick explanation
About the formula
Ke=div*(1+g)/P+g
I wonder why is g added as a second augend.
Could it be explained in this way?
The sh.holders want to have growth not only for the dividends but for the whole business, i.e. for the P (price of a share), so the total sum of a year return = div(1+g) + P*g. The percent of return = Ke = total_growth / P = we come to the initial formula. Is it correct?
Not really.
It is a rearrangement of the formula for the market value (Po) which can only be properly explained by proving it. It is easy to prove if you are good at maths.
However, both explaining and proving it are outside the syllabus 馃檪
Yeah that’s the correct.
K = [ D(1+g) + g] / P
Rearranging
K = [D(1+g) + P*g] / P
K = (Dividend growth + Price growth) / Price
K = Total Growth / Price
Hi John,
Question 6 part b needs calculation of cost of equity. The question has given a MV of $2.80 and EPS of 32c. Can’t we use the formula for cost of equity = 1/Price earning ratio ?
No – that doesn’t give the cost of equity!! That gives the earnings per share, which is something different.
Have you not watched the free lectures on this?
Hi John,
The answer to example 4 is coming negative -0.48. It’s not coming 4.19%. I have tried doing it multiple times!
Can you please check this?
g=(33000/28000)^1/4 -1= 1.0419 -1= 0.0419= 4.19%
Thank you Marslan 馃檪
Ayeshatabani, If the value has grown during the time (from 28k to 33k), how is it possible the the growth is negative? Must be positive! 馃檪
Thank you sir. I was wondering though….why we need to plus the growth, when it was already added to the dividend,,,,do x 1+g for next year’s dividend. Thanks
Because dividends keep growing after next years dividend. To explain fully would require me to prove the formula – it is not difficult to prove but would be wasting time given that you cannot be asked to prove it in the exam 馃檪
Hello Sir,
Thank you for the lectures,
I have a question concerning the example 6 part C: Market value per share in 2 years time:
Is ‘g’ dividend growth equal to the growth in share price?
Thank you again
I just need more explanation please
Yes. Because the market value is the present value of future dividends, the market price will grow at the same rate as the growth in dividends.
It makes sense, thank you sir
You are welcome 馃檪
Thanks a lot.
You are welcome 馃檪
I鈥檓 a bit unclear how you got the answer for the example 3.1 under chapter 6. (1+g) = 4 root (33,000/28,000).
But I explain this example in the lecture! If you are asking how to calculate a fourth root, then you need a scientific calculator.
Thanks Sir I used the wrong process.
You are welcome 馃檪
Hi,
1) Discounting dividend give current value of company.
2) Discounting entire cash flow also give current value of company.
So my question is how the dividend valuation model and discounted cash flow model give same result when cash flow include dividend also?
Discounting dividends at the cost of equity gives the value of the equity.
Discounting the free cash flows at the WACC gives the value of the company – equity plus debt.
What if the cash flow is after interest that is cash flow to equity?
Yes, and this is all explained in later lectures on the valuation of mergers and acquisitions – I do not know why you are asking this under a lecture on cost of capital!
In that lecture cash flow to equity is discounted with cost of equity, dividend valuation also with cost of equity so I got confused.
I got this doubt, when I watched this video. Sorry and leave it.
Thanks for the reply
You are welcome, and no problem 馃檪
I don’t understand how the 110 is appearing in example 8 part a of chapter 6….plz help
Hello sir,
In a situation where dividend grows at a given rate for a given number of years, who can cost of equity be computed?
Given that the dividend valuation formula is working backwards from the premise that the market value is the present value of future expected dividends discounted at the shareholders required rate of return, it would be illogical for shareholders to be expecting dividends as you state (and could not happen in the exam).
Revising this by watching the relevant PM (old F9) lectures may help you.
Most commonly in the exam we would be using CAPM to calculate the cost of equity anyway (and not using the dividend valuation formula.