Cost of Equity The cost of equity is the return required by equity investors given the risk of the cash flows from the firm There are two major methods for determining the cost of equity Dividend growth model SML or CAPM 5
5 Cost of Equity n The cost of equity is the return required by equity investors given the risk of the cash flows from the firm n There are two major methods for determining the cost of equity q Dividend growth model q SML or CAPM
The Dividend Growth Model Approach Start with the dividend growth model formula and rearrange to solve for RE D P 三 0 R E g D R E 二 + 8 P 6
6 The Dividend Growth Model Approach n Start with the dividend growth model formula and rearrange to solve for RE g P D R R g D P E E 0 1 1 0
Example:Dividend Growth Model Suppose that your company is expected to pay a dividend of $1.50 per share next year. There has been a steady growth in dividends of 5.1%per year and the market expects that to continue.The current price is $25.What is the cost of equity? 1.50 RE= +.051=.111 25
7 Example: Dividend Growth Model n Suppose that your company is expected to pay a dividend of $1.50 per share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $25. What is the cost of equity? .051 .111 25 1.50 RE
Example:Estimating the Dividend Growth Rate One method for estimating the growth rate is to use the historical average o Year Dividend Percent Change 2003 1.23 2004 1.30 (1.30-1.23)/1.23=5.7% 2005 1.36 (1.36-1.30)/1.30=4.6% 2006 1.43 (1.43-1.36)/1.36=5.1% ▣2007 1.50 (1.50-1.43)1/1.43=4.9% Average=(5.7+4.6+5.1+4.9)/4=5.1% 8
8 Example: Estimating the Dividend Growth Rate n One method for estimating the growth rate is to use the historical average q Year Dividend Percent Change q 2003 1.23 q 2004 1.30 q 2005 1.36 q 2006 1.43 q 2007 1.50 (1.30 – 1.23) / 1.23 = 5.7% (1.36 – 1.30) / 1.30 = 4.6% (1.43 – 1.36) / 1.36 = 5.1% (1.50 – 1.43) / 1.43 = 4.9% Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%
Advantages and Disadvantages of Dividend Growth model Advantage -easy to understand and use Disadvantages o Only applicable to companies currently paying dividends Not applicable if dividends aren't growing at a reasonably constant rate Extremely sensitive to the estimated growth rate -an increase in g of 1%increases the cost of equity by 1% Does not explicitly consider risk 9
9 Advantages and Disadvantages of Dividend Growth Model n Advantage – easy to understand and use n Disadvantages q Only applicable to companies currently paying dividends q Not applicable if dividends aren’t growing at a reasonably constant rate q Extremely sensitive to the estimated growth rate – an increase in g of 1% increases the cost of equity by 1% q Does not explicitly consider risk