Page 103 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes 12.154
= +0.05
243.10
= 0.050 + 0.05 = 0.10 × 100 = 10 per cent
Illustration 11: (Variable growth rates): A textile company’s dividends have been expected to
grow in the following manner.
1 – 2 years 15 per cent
3 – 5 years 10 per cent

6 year and beyond 5 per cent
The company currently pays a dividend of 2 per share, which is currently selling at 75 per
share. What would be the cost of equity capital assuming a fixed dividend pay out ratio?

Solution:

n D 1+gr  t D 1
NP =  0 t + n+1 × n
t=1 1+ K e  K - g n 1+ K e 
e
2.3 2.645 2.9095 3.200 3.52 3.52(1+0.05) 1
75 = 1 + 2 + 3 + 4 + 5 + 5 × 5
1+K e  1+K e  1+K e  1+K e   1+K e   1+K e   1+K e 




= 2.3 PVIF 1.K e  + 2.645 PVIF 2.K e + 2.9095 PVIF 3.K e  + 3.2 PVIF 4. e K  +
3.696 PVIF 6.K 
3.52 PVIF 5.K  + e
K - 0.05
e
e
By trial and error method using PV tables, we find K = 14%
e
First trial at 14%

3.696
75 = 2.3(0.877)+ 2.645(0.769)+ 2.909(0.675)+3.2(0.592)+ 3.52(0.519)+ ×(0.456)
0.14 - 0.05
75 = 2.02 + 2.03 + 1.96 + 1.89 + 1.83 + 18.73
75 = 28.5
Here, 75 is not equal to 28.5, for increasing the 28.5 to 75 we have to try at a lower rate, say 6%

3.696
75 = 2.3(0.943)+ 2.645(0.890)+ 2.907(0.840)+3.2(0.823)+ 3.52(0.747)+ ×(0.705)
0.06  0.05
= 2.17 + 2.35 + 2.44 + 2.63 + 2.63 + 260.568 = 272.79
New PV of cash out flows exceeding cash inflow. So, we will use interpolation formula

 272.79 – 75 
K = 6%+  14% – 6%  
e  272.79 – 28.5 

 197.79 
= 6%+ 8%  
 244.29 
Ke = 6% + 6.48 = 12.48 per cent.

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