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a)ARDA p/l is an all equity company with 15 million $1 ordinary shares in issue.Its ordinary shares currently stand at $2.75(2005).The dividend for this year has just been paid
Financial Data EPS……. Dividend per share
2001 – 14………….10
2002 – 28…………12
2003 – 34 ……… 15
2004 – 45 ……… 18
2005 – 58 — 22
NB ;Book value of equity/share was $3.78 in 2005
You are required to estimate the cost of equity capital using:
i)Dividend growth model
ii)Earnings retention modelIn both cases you have to use the formula:
Cost of equity = Ke = (Do (1 + g))/Po + g
(The formula on the formula sheet for Po, but rearranged).
Do is 22; Po is 275
The difference between the two models is how we estimate g – the dividend growth rate per annum.
For (i) we calculate the average growth p.a. in the past: (4th root of (22/10)) – 1
For (ii) we use the formula from the formula sheet g = b x r
Here there is no one correct answer – you could do several things.
To calculate b (the retention rate) you could calculate the average retention rate, or (and I think more sensible here) the most recent retention rate ( (58-22)/22 )
For r (the accounting rate of return) you have no choice but to use the latest year and it is 58/378.Hope that helps.
(If you need more examples, then I work through more examples in my lectures)
(I don’t know where you found this example, but one thing is rather odd – you would not normally expect the market value of a share to be lower than the book value on the balance sheet)
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