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Lecture Investment analysis & portfolio management - Chapter 15

After studying this chapter you will be able to understand: Cost of equity - dividend with constant growth (example), cost of preference shares, cost of debt – terminology, tax on interest, irredeemable debt, redeemable debt, convertible debt, efficient market hypothesis. | Investment Analysis Lecture: 15 Course Code: MBF702 Outline RECAP Cost of equity - Dividend with constant growth (example) Cost of preference shares COST OF DEBT – terminology Tax on interest Irredeemable debt Redeemable debt Convertible debt EFFICIENT MARKET HYPOTHESIS Cost of equity Dividend with constant growth - Recap This constant growth rate of dividends can be estimated using either of two methods. Example A company has 300,000 ordinary shares in issue with an ex-div market value of £2.70 per share. A dividend of £40,000 has just been paid out of post-tax profits of £100,000. Net assets at the year end were valued at £1.06m. Estimate the cost of equity. Solution Cost of equity Illustration A plc is all equity financed and has 1m shares quoted at £2 each ex div. It pays constant annual dividends of 30p per share. It is considering adopting a project which will cost £500,000 and which is of the same risk as its existing activities. The cost will be met by a rights issue. The project will produce inflows of £90,000 pa in perpetuity. All inflows will be distributed as dividends. What is the new value of the equity in A plc and what is the gain to the shareholders? Ignore tax. Cost of equity Illustration Cost of equity Illustration The NPV of the project serves to increase the value of the equity shareholders’ shares. Imp Aspects Limitations of the model Method is not applicable for companies paying no or very low cash dividend. If g > Ke, the method fails Retained profits may not earn enough profit to maintain the dividend stream Important MISTAKE to note If formula applies at later than Yr ‘0’, discount the value of ‘E’ here and dividends in interim years at the required rate of return of shareholder, i.e. Ke to obtain ‘E’ Cost of preference shares By definition preference shares have a constant dividend If you have cumulative preference shares, the MV is increased by the outstanding amount to be paid. Preference dividends are normally quoted as a percentage, e.g. 10% preference shares. This means that the annual dividend will be 10% of the nominal value, not the market value. Share prices change, often dramatically, on a daily basis. The dividend valuation model will not predict this, but will give an estimate of the underlying value of the shares. Example A company has 100,000 12% preference shares in issue (nominal value £1). The current ex-div market value is £1.15 per share. What is the cost of the preference shares? Solution Thank you | Investment Analysis Lecture: 15 Course Code: MBF702 Outline RECAP Cost of equity - Dividend with constant growth (example) Cost of preference shares COST OF DEBT – terminology Tax on interest Irredeemable debt Redeemable debt Convertible debt EFFICIENT MARKET HYPOTHESIS Cost of equity Dividend with constant growth - Recap This constant growth rate of dividends can be estimated using either of two methods. Example A company has 300,000 ordinary shares in issue with an ex-div market value of £2.70 per share. A dividend of £40,000 has just been paid out of post-tax profits of £100,000. Net assets at the year end were valued at £1.06m. Estimate the cost of equity. Solution Cost of equity Illustration A plc is all equity financed and has 1m shares quoted at £2 each ex div. It pays constant annual dividends of 30p per share. It is considering adopting a project which will cost £500,000 and which is of the same risk as its existing activities. The cost will be met by a rights issue. The .