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Corhig Co is a company that is listed on a major stock exchange. The company has struggled to maintain profitability in the last two years due to poor economic conditions in its home country and as a consequence it has decided not to pay a dividend in the current year. However, there are now clear signs of economic recovery and Corhig Co is optimistic that payment of dividends can be resumed in the future. Forecast financial information relating to the company is as follows:
year 1 2 3
earnings 3000 3600 4300
div nil 500 1000The company is optimistic that earnings and dividends will increase after Year 3 at a constant annual rate of 3% per year.
Corhig Co currently has a before-tax cost of debt of 5% per year and an equity beta of 1•6. On a market value basis, the company is currently financed 75% by equity and 25% by debt.
During the course of the last two years the company acted to reduce its gearing and was able to redeem a large amount of debt. Since there are now clear signs of economic recovery, Corhig Co plans to raise further debt in order to modernise some of its non-current assets and to support the expected growth in earnings.
This additional debt would mean that the capital structure of the company would change and it would be financed 60% by equity and 40% by debt on a market value basis. The before-tax cost of debt of Corhig Co would increase to 6% per year and the equity beta of Corhig Co would increase to 2.
The risk-free rate of return is 4% per year and the equity risk premium is 5% per year. In order to stimulate economic activity the government has reduced profit tax rate for all large companies to 20% per year.
The current average price/earnings ratio of listed companies similar to Corhig Co is 5 times.
Required:
Calculate the current cost of equity of Corhig Co and, using this value, calculate the value of the company using the dividend valuation model.In the answers it says, Cost of equity equals K(e)=Rf + B(e)(Market premium)= 4 + 1,6*5)
Okay i get that, But my question is “SHOULDNT WE UNGEAR AND REGEAR?? BECAUSE THE GEARING OF THE COMPANY CHANGES? PLEASE HELP”
P.S I thought we need to use this technique ungear/regear and then CAPM formula… a bit confused…Please don’t type out full exam questions – they are copyright of the ACCA. I have all the past exam questions and so I can find them myself.
The question specifically says to calculate the current cost of equity and then says ‘using this value’. So why do you want to do different than what the question tells you to do?
Gearing and ungearing is of no relevance when you are asked for the current cost of equity and (implicitly) the current market value.
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