EC5603 ectures 4 5.docxVIP

BRUNEL UNIVERSITY Department of Economics and Finance EC5603 Business Finance: LECTURES 4 5 The Costs of Debt, Equity and the Weighted Average Cost of Capital (WACC) Reading: Lumby Chaps 16 17 SWB Chap 15, 16 18 Arnold Chap 8 (1) INTRODUCTION Up to now, we have considered three sources of finance available to firms to finance their investment projects: (1) Equity finance (2) Debt Finance (3) Retained earnings Ultimately, it is the cost of capital that determines the choice between the different sources. (2) THE COST OF EQUITY CAPITAL The cost of equity capital is simply the investors required rate of return on equity. (3) EXTRACTING KE FROM THE DVM If we let Pe = market price per share Ve = total market value of equity i.e. Pe ? no’ of shares issued. dt = div per share paid at time t Dt = total div paid to equity holders at time t i.e. dt ? no’ of shares issued Ke = cost of equity capital (expected return on equity) then the DVM can be expressed as either or If we assume that the future div flow will remain at a constant level for all future time periods (i.e. in perpetuity) then the model can be simplified into the following form: or therefore Example: A share has a cum div market price (price just prior to the div being paid) of ￡1.59 and is expected to yield a constant annual dividend of 22p. Calculate the cost of equity capital. We know that Where d is the constant div per share expected to be paid in all future periods i.e. 22p Pe is the ex div market price per share i.e. it the market price per share just after the div has been paid ? Pe = ￡1.59 -22p = ￡1.37 Thus, (4) CALCULATING KE WHERE THERE IS GROWTH IN DIVS We have already seen the Dividend Growth Model which allows divs to grow at a constant rate g through time: or alternatively, Both of these models can be rearranged to give the cost of equity capital where divs are growing at a constant rate: or alternatively, Example: Suppose a co’, whose ex div market price per share is 70p, h