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MR John, I am having difficulty in interpreting this question as well as understanding the solution
Mr Gable has just received a dividend of $1,000 on his shareholding in Gonwithy Windmills. The market value of the shares is $8,000 ex div. What is the (nominal) cost of the equity capital, if dividends are expected to rise because of inflation by 10% in years 1, 2 and 3, before levelling off at this year 3 amount?
Solution
The nominal cost of equity capital is the internal rate of return of the following cashIRR is 16%
SolutionYear. CF PV@15%. PV@20%
0 (8,000) 1.000 (8,000). 1.000. (8000)
1 1,100 0.870 957 0.833. 916
2 1,210 0.756 915. 0.694. 840
3-*. 1,331 pa 5.041 6,709. 3.472. 4621
NPV 581. NPV (1623)
The IRR is 16%
* The present value factor = (Factor 1 – ) – (Factor yrs 1-2).
For 15%
PV factor: 1/0.15 – 1.626
=5041For 20%
PV factor: 1/0.2 – 1.528
= 3.472Why is IRR = money cost of capital?
Why is it there a different calculation in the PV factor? Perpetuity should be 1/r, why the perpetuity calculation is diff for year 3?
The PV of a perpetuity is arrived at by multiplying by 1/r when the perpetuity starts in 1 years time.
If the perpetuity starts in 3 years time, then it starts 2 years late and so to get the discount factor for 3 to infinity they have subtracted the annuity factor for 2 years.No – you meed to multiply by the 2 year factor (because it starts 2 years late) and you will get the same answer 🙂
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