5 Gordon MJ 1962 The investment Financing and Valuation of the Corporation also

5 gordon mj 1962 the investment financing and

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5 Gordon, MJ (1962), The investment, Financing and Valuation of the Corporation ; also ‘Optimum investment and financing policy’, Journal of Finance , May 1963, pp. 264-72; ‘The savings, investment and valuation of a corporation’, Review of Economics and Statistics , February, 1962, pp.37-51. [136]
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2. The required rate of return r and cost of equity, k E are constant. 3. The firm has a perpetual life (i.e. operates forever). 4. The firm’s dividend policy and retention ratio ( b ), once decided upon, do not change. Thus, the growth rate, ( g = br ) is also constant. 5. cost of equity, k E > the growth rate, ( g = br ) Based on the GGM, investors, being rational, want to avoid risk (the probability of not getting a return on investment); thus, the consistent payment of dividends completely removes any chance of risk. If, however, the firm retains the earnings the investor can expect to get the dividend in future. According to Gordon, investors view retained earnings as a risky promise and future dividend payment as uncertain. So the rational investor can reasonably be expected to prefer current dividend. Hence, the bird-in-hand being better than two birds in the bush based on the logic that what is available at present is preferable to what may be available in the future (Khan and Jain, 2009: 3016). The cost of equity is related to its dividends in the next time period , current value of a stock, and the expected dividend growth rate in perpetuity. Thus, Cost of equity ,k E is : k E = D 1 P 0 + g [137]
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k E = D 0 P 0 ( 1 + g )+ g Where, D 0 = current dividends paid/declared D 1 = dividends in the next time period P 0 = current market value (price) per share g = dividend growth rate 4.2.2.2. COST OF PREFERENCE SHARES The cost of preference shares is computed as: k P = D P 0 Where, D = fixed interest rate on the preference shares x par value of the preference shares, and P 0 = current market value (price) per share 4.2.2.3. COST OF DEBENTURES The Cost of Debentures (same approach for calculating any bond really) is computed as: k P = Yield ¿ maturity ratex ( 1 Tax Rate ) YTM is defined as the interest rate that will make the present value of a debentures remaining cash flows (if held to maturity) equal to its current market price. Yield-to-maturity is the rate at which the company could borrow today. [138]
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4.2.2.4. COST OF BANK LOANS The Cost of Bank loans is computed as: k BL = Interest Rateonthe loan x ( 1 Tax Rate ) In real life, most companies have a vast array of securities that make up their capital market structure. NOTE: the firm’s reserves and retained earnings do NOT feature in the calculations of WACC because they are internally generated capital (i.e. they are not capital raised outside the firm and therefore do not have any cost to the firm). EXAMINATION EXAMPLE 1: The Directors of Erasmia Industries have appointed you as their financial consultant. They are seeking new project investments and require you to calculate the present cost of capital of the company.
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