1. F9 Financial Management

2. 2 Designed to give you the knowledge and application of: Section F: Cost of capital F1. Sources of finance and their short-term finance F2. Estimating the cost of equity F6. Impact of cost of capital on investments

3. 3 Learning Outcomes F2. Estimating the cost of equity  Dividend growth model and its weaknesses. [2]  Describe Capital asset pricing model (CAPM). [2]  Discuss advantages and disadvantages of the CAPM. [2]

4. 4 Where, P 0 = Current ex dividend market price of the share D 0 = Declared dividend at time t r e = Shareholders’ required rate of return (K e = Cost of equity) g = Expected future growth rate of dividends D 0 (1 + g) D 0 (1 + g) P 0 = -------------- Therefore, r e or K e = --------------- + g (r e – g ) P 0 The value of the stock equals next year's dividends divided by the difference between the required rate of return and the assumed constant growth rate in dividends. An approach that assumes dividends grow at a constant rate in perpetuity. Dividend growth model Continued …

5. 5 According to Gordon, dividend growth rate depends upon Where, g = growth rate of dividend r e = post tax returns on equity b = the proportion of profits re-invested Post tax return on equity Proportion of profits reinvested Relationship g = br e Continued …

6. 6 Rate of post-tax return on equity of a company is 12%. What will its expected rate of growth in dividends be if the ‘retention ratio’ or the proportion of profits reinvested is: 80% or 50%? Answer For the retention ratio of 80% G= br e = 0.12 x 0.80 = 0.096 = 9.6%. For the retention ratio of 50% G= br e = 0.12 x 0.50 = 0.06 = 6.0%. Example

7. 7 Malco provides the following information: Current ex dividend market price of the share46.52 Dividend paid currently 4 Expected future growth rate of dividends3.50% Calculate the cost of equity capital. Example Continued …

8. 8 Calculation of the cost of equity capital D 0 (1+ g) Ke = -------------- +g P 0 4 (1 + 3.50%) =-------------------- +3.50% 46.52 4 x 1.035 =-------------------- +0.035 46.52 4.14 =-------------------- +0.035 46.52 =0.08899398 +0.035 =0.12399398 =12.40% Continued …

9. 9 No assurance of growth of dividend in the future Other influences on the share prices are ignored The share prices are mathematically discounted to get the present value The growth model fails to consider capital gains Other assumptions, which may not hold true in practice are:  investors behave rationally  expected future growth rates of dividends can be estimated  investors’ expectations are predictable and they can be modeled into a discounted cash flow  the company’s earnings will increase continuously to maintain dividend growth in future Assumption and weaknesses of dividend growth model Weakness of dividend growth model

10. 10  The higher the risk, the higher the return expected by investors  Security market line denotes the relationship  Fitted line based on actual data indicates that there is strong relationship between systematic risk and return E (r j ) = R f +  j (E(r m ) – R f ) Where, E (r j ) = Rate of return of security j, as projected by model  j = Beta coefficient of security j, R f = Risk-free rate of return, E(r m )= Return of the market (RM) Relationship  CAPM is an important area of financial management  Finance only become a fully – fledged, scientific discipline’ when William Shapre published his derivation of the CAMP in 1986 CAPM model Continued …

11. 11 Investors hold diversified portfolios Single – period transaction horizon Investors can borrow and lend at the risk – free rate of return Investors hold diversified portfolios Assumption of the Capital Asset Pricing Model (CAPM)  The investors will only require a return for the systematic risk of their portfolios, since unsystematic risk has been removed and can be ignored  A standardised holding period is assumed by the CAPM in order to make comparable the returns on different securities  A return over six months, for example, cannot be compared to a return over 12 months.  This is an assumption made by portfolio theory, from which the CAPM was developed, and provides a minimum level of return required by investors.  There are no taxes or transaction cost Continued …

12. 12  Investors make choices on the basis of risk and return. Investors choose only those portfolios with the with the highest rate of return for their preferred level of risk, or those with the lowest risk for their preferred rate of return.  Investors have homogeneous expectation of risk and return  Investors have identical time horizon.  Information is freely and simultaneously available to investors  There is a risk free asset, and investors can borrow and lend unlimited amounts of risk free rate.  There are no taxes, transaction costs, restrictions on short rates, or other market imperfections.  Total asset quality is fixed and all assets are marketable and divisible. This assumption suggests that we can ignore liquidity and new issue of securities.  Securities markets are efficient and a signal investor can not affect the price.  All investors are in efficiently diversified and have eliminated the unsystematic risk. Thus, only systematic risk is relevant in determining the estimated return. Assumption of the Capital Asset Pricing Model (CAPM)

13. 13 a.BETA : The calculation of the beta factor of data is required. The beta factor can be found by examining the securities historical return relative to the return of the market portfolio. Further, the beta factor may or may not reflect the future variability of returns. The beta factor cannot be expected to be constant over time. It must be updated frequently. b.The assumptions of the CAPM are hypothetical and are impractical. For example, the assumption of borrowing and lending at the same rate is imaginary. In practice, the borrowing rates are higher than the lending rates. Limitation of the Capital Asset Pricing Model (CAPM)

14. 14 Example Calculate the cost of capital of Zodiac on the basis of the following data: The beta coefficient of Zodiac’s ordinary shares 1.25 The rate of return on government securities, which are treated as risk-free 5% The stock exchange index at 31 December 20X7: 11,440 The stock exchange index at 31 December 20X6: 10,400 Average dividend yield of the stock exchange index for 20X7: 6% Calculate the cost of ordinary share capital for Zodiac. Example Continued …

15. 15 First we have to calculate return of market (RM) P 1 – P 0 RM = ------------ + Div P 0 11,440 – 10,400 = --------------------------- + 6% 10,400 = 0.10 + 0.06 = 0.16 = 16% Now, we can calculate the rate of return of ordinary shares of Zodiac (Rj ), as projected by the model E(r j ) = R f + β j (E(r m ) – R f ) = 0.05 + 1.25 (0.16 - 0.05) = 0.05 + 0.1375 = 0.1875 = 18.75% The cost of ordinary share capital of Zodiac, therefore, is 18.75% Continued …

16. 16 Beta coefficient of the security Risk – free rate of return Return of the market Systematic risk Unsystematic risk Components CAPM model

17. 17 Systematic risk associated with the companies shares Systematic risk of the capital market as a whole Comparison between The degree of volatility Beta < 1 (less sensitive to systematic risk than average investment) Beta = 1 (similar to market profile and average risk) Beta > 1 (not as sensitive and below the average risk) BETA Continued …

18. 18 Asset BetaEquity BetaDebt Beta  No debt and no financial risk  Its beta value reflects business risk alone  A company’s business operations as a whole  As long as a company’s business operations, and its business risk, do not change, its asset beta remains constant.  No debt  Gearing and financial risk is increases  It is added to its business risk  Shareholders faces an increasing level of risk  Returns increases to compensate for the increasing risk  Equity beta increases as gearing increases  The debt beta reflects the financial risk borne by shareholders due to the entity’s use of debt financing.  Part of the company corporate finance strategy Continued …

19. 19 Systematic risk Cannot be eliminated by portfolio diversification Systematic risk can be mitigated only by being hedged. Interest rates, recession and wars all represent sources of systematic risk The risk inherent to the entire market or entire market segment. It is also known as "un-diversifiable risk" or "market risk." It is associated with the financial system and is effect due to the general economic factors Unsystematic risk Can be eliminated by portfolio diversification It is associated with the individual companies and the shares they have issued Company specific factors The amount of unsystematic risk can be reduced through appropriate diversification. It is also known as "specific risk", "diversifiable risk" or "residual risk". It is company or industry specific risk that is inherent in each investment. RISK Continued …

20. 20 Risk – free rate of return  Bonds issued by the government of a politically and economically stable country are treated as being risk-free for this purpose.  The rate of return or yield on such short-term bonds is taken as an approximation of risk-free return.  Required by investors to compensate them for investing in a risk-free investment  It compensates for inflation and consumption preference Continued …

21. 21 Profits (yield) paid in the form of dividend to shareholders Return of the market P 1 – P 0 R m -------------- + Div P o Where, R m = Return of market P 1 = The stock exchange index at the end of the period P 0 = The stock exchange index at the beginning of the period Div = Average dividend yield of the stock exchange index for the period Capital gainsDividend yield Profit earned from the sale of capital assets Market return

22. 22 The advantages and disadvantages of CAPM DisadvantagesAdvantages No certainty about the future as beta is based on past performance Easy to use and understand Fails to explain variations in returnLinks required return directly to risk Difficult to assess model inputs accurately Market rate given importance as benchmark If company does not trade publicly, historical data will not be available Founded on reasonable and standard behaviour patterns Variance of returns is taken as a normal measurement of risk Applicable to companies whether they pay dividend or not Stability of Beta  Betas from the past are taken as an indication of expected betas in the future  For which the beta coefficients remains stable  The stability of individual betas are inconclusive

23. 23 Recap  Dividend growth model and its weaknesses. [2]  Describe Capital asset pricing model (CAPM). [2]  Discuss advantages and disadvantages of the CAPM. [2]

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