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I am attempting past exams and cannot understand how the value of AggroChem is calculated in pat (i) of the question. It seems Gordon’s growth model has been mixed with cach flow model. Can you help?
the growth model calculates the PV of a growing dividend in perpetuity, but you can use the same formula to get the PV of any flows that are growing at a constant rate in perpetuity.
for the Aggrochem 2010 qn,
for exercise price (Pe) – don’t we need to put Debt value as at End of Year 5 rather than PV (i.e Y0 value),
since BSOP formula it self doing the discounting function by “e” for exercise price.same term to maturity (5yrs) and yield (8%) , don’t we need to put Pe as ( 3.000* 1.08^5 = 4.407) ?
But in question it is worded as, take the PV of equivalent zero coupon bond and in answer taken as 2.04175.
could you please advise
Two things:
Firstly the question specifically says that the exercise price is to be the present value of the equivalent zero coupon bond, which is what the answer has done.
Secondly, although the use of ‘e’ in the Black Scholes formula is indeed to do continuous discounting, it is for a different reason – it is taking account of the fact that we do not have to pay out the money to exercise ‘now’ but can exercise at a later date.
Hi John,
It’s the same question.
For (i), the examiner uses Ke when using Gordon’s growth approximation to calculate the growth rate. I thought using Return on Capital Employed. I don’t understand why the examiner use Ke which is required return by shareholder while Gordon’s formula uses Re (g=b x Re) which is return on investment. Did I misunderstand using Return on Capital Employed for Gordon’s formula? Why examiner uses Ke in this question?
Many thanks in advance.
Re and Ke are the same thing – the shareholders required return (Re) will also be the cost of equity to the company (Ke).
Thanks John!
When I read BPP Study Text, the formula is g=br where r is the rate of return on new investment. So I always thought using Return on Capital Employed for this formula but now found it’s wrong.
Q1 Dec 2014 used Return on Equity 11% to calculate growth rate of Fugae Company when using Gordon’s formula. Does it mean Return on Equity is same as Ke (Cost of Equity) but in different name?
Many thanks in advance!
That is what I wrote before – the shareholders required return (i.e. return on equity) is the same as the cost of equity.
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