Page 103 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 6: Cost of Capital

Cost of Capital under Variable Growth Rate: The computation cost of equity after a specific Notes
period, is based on the estimation of growth rate in dividends of a company. Expected growth
rate will be calculated based upon the past trend in dividend. It may not be unreasonable to
project the trend into the future, based on the past trend. The financial manager must estimate
the internal growth rate in dividends on the basis of long range plans of the company. Expected
growth rate in the internal context requires to be adjusted. Compound growth rate in dividends
can be computed with the following formula.
gr = D (1 + r) = D
o n n
Where,
gr = Growth rate in dividends
D = First year dividend payment
o
(1 + r) n = Present value factor for ‘nth’ year
D = Last year dividend payment.
n
Illustration 9:

From the following dividends record of a company, compute the expected growth rate in
dividends.

Year 1996 1997 1998 1999 2000 2001 2002 2003
Dividends per share ( ) 21 22 23 24 25 26 27 28

Solution:
gr = D (1 + r) = D = 21 (1 + r) = 28
7
o n n
(1 + r) 7 = 28 ÷ 21 (1 + r) = 1.334
7
During seven years the dividends has increased by 7 giving a compound factor of 1.334. The
growth rate is 4 per cent since the sum of 1 would accumulate to 1.334 in seven years at
4 per cent interest.
Illustration 10:
Mr. A an investor, purchases an equity share of a growing company for 210. He expects the
company to pay dividends of 10.5, 11.025 and 11.575 in years 1, 2 and 3 respectively and he
expects to sell the shares at a price of 243.10 at the end of three years.
1. Determine the growth rate in dividends.

2. Calculate the current dividend yield.
3. What is the required rate of return of Mr. A on his equity investment?
Solution:

1. Computation of growth rate (gr)
n
2
gr = D (1 + r) = D = 10.5 (1 + r) = 11.575
o n
11.575
(1 + r) 2 =
10.5
(1 + r) 2 = 1.103
gr = 5 per cent

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