Dividend growth model
Total dividends of $40 million are expected to grow at 4% per year and Close Co has a cost of equity of 10%.
Value of company = (40m x 1·04)/(0·1 – 0·04) = $693 million
Earnings yield method
Profit after tax (earnings) is $66·6 million and the finance director of Close Co thinks that an earnings yield of 11% per year
can be used for valuation purposes.
Ignoring growth, value of company = 66·6m/0·11 = $606 million
Alternatively, profit after tax (earnings) is expected to grow at an annual rate of 5% per year and earnings growth can be
incorporated into the earnings yield method using the growth model.
Value of company = (66·6m x 1·05)/(0·11 – 0·05) = $1,166 million
Examiner’s note: full credit would be gained whether or not growth is incorporated in the earnings yield method.
(b) The dividend growth model (DGM) is used widely in valuing ordinary shares and hence in valuing companies, but there are
a number of weaknesses associated with its use.
The future dividend growth rate
The DGM is based on the assumption that the future dividend growth rate is constant, but experience shows that a constant
dividend growth rate is, in reality, very rare. This may be seen as less of a problem if the future dividend growth rate is
regarded as an average growth rate.
Estimating the future dividend growth rate is very difficult in practice and the DGM is very sensitive to small changes in this
key variable. It is common practice to estimate the future dividend growth rate by calculating the historical dividend growth,
but the assumption that the future will reflect the past is an easy one to challenge.
The cost of equity
The DGM assumes that the future cost of equity is constant, when in reality it changes quite frequently. The cost of equity
can be calculated using the capital asset pricing model, but this model usually employs historical information, which may not
reflect accurately expectations about the future.
Zero dividends
It is sometimes claimed that the DGM cannot be used when no dividends are paid, but this depends on whether dividends
are expected in the future. If dividends are forecast to be paid from a future date, the dividend growth model can be applied
at that point to calculate a share price, which can then be discounted to give the current ex dividend share price. Only in the
case where no dividends are paid and no dividends are expected to be paid will the DGM have no application.
(c) Market value of equity
Close Co has 80 million shares in issue and each share is worth $8·50 per share.
The market value of equity is therefore 80 x 8·50 = $680 million
Cost of equity
This is given as 10% per year.
Market value of 8% bonds
The market value of each bond will be the present value of the expected future cash flows (interest and principal) that arise
from owning the bond. Annual interest is 8% per year and the bonds will be redeemed at their nominal value of $100 per
bond in six years’ time. The before-tax cost of debt is given as 7% per year and this is used as a discount rate.
14Present value of future interest = (8 x 4·767) = $38·14
Present value of future principal payment = (100 x 0·666) = $66·60
Ex interest bond value = 38·14 + 66·60 = $104·74 per bond
Market value of bonds = 120m x (104·74/100) = $125·7 million
After-tax cost of debt of 8% bonds
The before-tax cost of debt of the bonds is given as 7% per year.
After-tax cost of debt of bonds = 7 x (1 – 0·3) = 7 x 0·7 = 4·9% per year
Value of the 6% bank loan
The bank loan has no market value and so its book value of $40 million is used in calculating the weighted average cost of
capital.
