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Question 52 WEB Co- BPP Kit. (wacc)
3rd paragraph: Dividends have grown in the past at 3% a year, resulting in an expected dividend of $1 per share to be declared on 31 May 2002. Due to expansion, dividends are expected to grow at 4% a year from 1 June 2002 for the foreseeable future. The price per share in currently $10.40 ex div and this is not expected to change before 31 May 2002
The question asks to prepare WACC at 31 May 2002. In the solution, while calculating the cost of equity, growth is taken as 4%. Why is it 4% and not 3% as this is the growth rate as at 31 may. Isn’t 4% with effect from 1 June?
Share prices are based on the expected future dividends – if you think a company will do well in the future you will pay more for the share, if you think it will do worse in the future then you will pay less.
So whenever we calculate the cost of equity (and are using the current share price) we should be taking into account the future expected growth.
(Past growth is not itself relevant, although we often take it into account in estimating what the future growth will be. If there was no information available about future growth, then (and only then) we would be forced to assume that growth in the future would continue at whatever rate it was in the past.)
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