Summary Cost of Capital
The Cost of Capital
1
Background
As investors desire to obtain the best/highest return on their investments in securities such as shares (Equity) and loans to companies such as debentures (Debt), these returns are costs to the companies paying these Dividends (on equity) and Interest (on
Debts)!
It all depends on the perspective from which we chose to view the calculation (are we Earning or Paying?)
Companies MUST consider the cost of financing they receive in the form of equity or debt if they are to manage their finances better; cheaper finance cost to the company means higher profitability and in most cases, superior cash flow. Generally, the cost of EQUITY has no tax effect but the cost of DEBT finance to companies are technically SUBSUDISED by tax since INTEREST (cost of Debt) can be claimed for tax purposes in so far as it is ‘wholly, exclusively and necessarily’ incurred for business purposes.
2
The Cost of Equity
Assumptions of the Dividend Valuation Model (DVM)
Investors only buy shares to acquire a future dividend stream.
All investors have homogeneous (i.e. identical) expectations of this future dividend stream.
The stock market is extremely efficient at pricing securities.
Present Value (PV) of dividend stream = current share price
(current market price of share).
REMEMBER:
Our focus is the COST OF EQUITY (shares/securities) NOT DEBT
(debentures)!
www.goldsmithibs.com
An Example: Assuming CONSTANT dividend streams of income
(Investors’ perspective)
A plc has paid a dividend of 50p per share for many years. This is expected to continue for the foreseeable future. A plc’s current share price is £2.50 ex div. You are required to calculate the cost of equity of X plc, Ke.
Solution:
Present value (PV) of dividend stream = current share price (see assumption 4 above please)
50p
Ke
=
250p
50 p
250 p
⇒ Ke =
= 20% per annum
Note:
Current share price used is Ex. Div. (i.e. without the next dividend payment). Constant dividend divided by Cost of Equity
1
Background
As investors desire to obtain the best/highest return on their investments in securities such as shares (Equity) and loans to companies such as debentures (Debt), these returns are costs to the companies paying these Dividends (on equity) and Interest (on
Debts)!
It all depends on the perspective from which we chose to view the calculation (are we Earning or Paying?)
Companies MUST consider the cost of financing they receive in the form of equity or debt if they are to manage their finances better; cheaper finance cost to the company means higher profitability and in most cases, superior cash flow. Generally, the cost of EQUITY has no tax effect but the cost of DEBT finance to companies are technically SUBSUDISED by tax since INTEREST (cost of Debt) can be claimed for tax purposes in so far as it is ‘wholly, exclusively and necessarily’ incurred for business purposes.
2
The Cost of Equity
Assumptions of the Dividend Valuation Model (DVM)
Investors only buy shares to acquire a future dividend stream.
All investors have homogeneous (i.e. identical) expectations of this future dividend stream.
The stock market is extremely efficient at pricing securities.
Present Value (PV) of dividend stream = current share price
(current market price of share).
REMEMBER:
Our focus is the COST OF EQUITY (shares/securities) NOT DEBT
(debentures)!
www.goldsmithibs.com
An Example: Assuming CONSTANT dividend streams of income
(Investors’ perspective)
A plc has paid a dividend of 50p per share for many years. This is expected to continue for the foreseeable future. A plc’s current share price is £2.50 ex div. You are required to calculate the cost of equity of X plc, Ke.
Solution:
Present value (PV) of dividend stream = current share price (see assumption 4 above please)
50p
Ke
=
250p
50 p
250 p
⇒ Ke =
= 20% per annum
Note:
Current share price used is Ex. Div. (i.e. without the next dividend payment). Constant dividend divided by Cost of Equity