Cost of Equity Approaches a Dividend discount model n Capital-Asset Pricing Model n Before-Tax Cost of Debt plus risk Premium 15-11
15-11 Dividend Discount Model Capital-Asset Pricing Model Before-Tax Cost of Debt plus Risk Premium Cost of Equity Approaches
Dividend discount odel The cost of equity capital, ke, is the discount rate that equates the present value of all expected future dividends with the current market price of the stock P (1+k)1(1+k)2(1+ka)° 15-12
15-12 Dividend Discount Model The cost of equity capital, ke , is the discount rate that equates the present value of all expected future dividends with the current market price of the stock. D1 D2 D (1+ke ) 1 (1+ke ) 2 (1+ke ) P + + . . . + 0 =
Constant Growth Model The constant dividend growth assumption reduces the model to: e=(D1/P0)+g Assumes that dividends will grow at the constant rate g forever. 15-13
15-13 Constant Growth Model The constant dividend growth assumption reduces the model to: ke = ( D1 / P0 ) + g Assumes that dividends will grow at the constant rate g forever
Determination of the Cost of Equity Assume that Basket Wonders Bw has common stock outstanding with a current market value of $64.80 per share, current dividend of $3 per share, and a dividend growth rate of 8% forever Ke =(D,/Po)+g e=($3(1.08)/$6480)+.08 ke=05+.08=.13or13% 15-14
15-14 Assume that Basket Wonders (BW) has common stock outstanding with a current market value of $64.80 per share, current dividend of $3 per share, and a dividend growth rate of 8% forever. ke = ( D1 / P0 ) + g ke = ($3(1.08) / $64.80) + .08 ke = .05 + .08 = .13 or 13% Determination of the Cost of Equity Capital
Growth Phases model The growth phases assumption leads to the following formula (assume 3 growth phases) a Do(1+g1)t a(1+g2)a 0-召1(1+k。F+=+1(1+kg ∑ D(1+g3) t=b+1(1+k)t 15-15
15-15 Growth Phases Model D0 (1+g1 ) t Da (1+g2 ) t-a (1+ke ) t (1+ke ) P0 = t The growth phases assumption leads to the following formula (assume 3 growth phases): + t=1 a t=a+1 b t=b+1 Db (1+g3 ) t-b (1+ke ) t +