financial management (mgt201)
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This is to inform that Assignment No. 1 (NON-GRADED) will be opened on February 06, 2014 and due date of assignment submission will be February 11, 2014.
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ABC Company is currently paying an annual common stock dividend of Rs. 3.30 per
share. The company’s dividend has grown gradually over the past nine years from Rs.
1.65 to its current level; this growth is expected to continue. The company’s present
dividend payout ratio, also expected to continue, is 40 percent. Moreover, the stock
presently sells at 8 times the current earnings.
ABC Company stock has a beta of 1.15, as computed by a leading investment advisory.
The present risk-free rate is 10.50 percent, and the expected return on the stock market
is 13 percent.
a. Calculate the ABC’s cost of equity capital using both the Dividend Discount
Model approach and Capital Asset Pricing Model approach.
b. Suppose you as an individual investor feel that 12 percent is an appropriate
required rate of return for the level of risk you perceive for ABC Company. Using
the dividend discount model and Capital Asset Pricing Model approaches,
determine whether you should purchase ABC Company stock or not.
c. ABC Company has estimated the various costs of debt for different proportions of
debt in its capital structure; you are required to determine the firm’s optimal
capital structure.
Proportion of Debt Cost of Debt
0 11.00%
25% 11.40%
50% 11.80%
75% 12.50%
100% 13.00%
Note: use cost of equity as calculated under Dividend Discount Model for part c.
2. Weighted average cost of capital
In order to calculate WACC, you need to know the values of the different components of the capital structure, that is the after tax cost of debt, the cost of preferred shares and the cost of common equity. Below, I will explain how to calculate all these components.
Cost of common equity
We need to determine, the cost of common equity in order to calculate the weighted average cost of capital. The idea behind the cost of equity is that, if a company used some of its earnings (retained earnings) to buy back its own shares then they can save the cost of common stocks. There are three main methods of estimating the cost of common equity: the capital asset pricing (CAPM) method, the dividend discount model approach (DDM) and the last approach is using the bond yield plus risk premium.
Capital Asset Pricing Model:
This approach to finding Kce involves estimating the risk free rate, Rf (usually this is given in an exam) otherwise it is the yield on a risk free debt with a maturity date close to the useful life of the project. Then you need to estimate the beta of the stock and the expected market return, Rm. The variables can then be fed to the CAPM model to obtain the cost of common equity. The CAPM model is given below:
