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]

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]

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]

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.

#### You've reached the end of your free preview.

Want to read all 281 pages?

- Fall '19
- Capital Asset Pricing Model, Financial Markets, 1984, Modern portfolio theory