Dividend Valuation Model:◦ Assume Re 1 share quoted at Rs. 2.50, dividend

just paid Rs. 0.20

ek

dP 0

%808.0

250

20ek

Dividend Growth Model:◦ Assume Re 1 share quoted at Rs. 2.50, dividend

just paid Rs. 0.20. Expected annual growth rate for the dividend is 5 per cent.

gk

gdP

e

)1(0

0

g

P

gdke

0

0 )1(

%4.13134.005.0

250

)05.1(20

ek

Historical dividend:◦ Year 2005: Rs. 15,000; Year 2006: Rs. 15,500;

Year 2007: Rs. 17,200; Year 2008: Rs. 18,100; Year 2009: Rs. 19,000

◦ Historical average annual growth is calculated using the compound interest formula.

nrXS )1 4)11500019000 g

%606.

06.115000

190001

4/1

g

g

Assumptions:◦ The entity must be all equity financed;◦ Retained profit is the only source of additional

investment;◦ A constant proportion of each year’s earnings is

retained for reinvestment; and◦ Projects financed from retained earnings earn a

constant rate of return

An entity retains 60 per cent of its earnings for identified capital investment projects that are estimated to have an average post-tax return of 12 per cent. bRg

Earnings

DividendEarningsb

ployedfcapitalemBookvalueo

EarningsR

%2.712%60 g

Capital Asset Pricing Model

fmfe RRRk

Kd net = Cost of debt (after tax) i= annual interest t= rate of corporation tax (assumed

immediately recoverable) P0 = market value of debt (ex-interest,

immediately after payment)◦ Assume 7 per cent bond quoted at cumulative

interest market price of Rs. 90 and corporation tax is 30 per cent

0

1

P

tikdnet

%4.5

790

30.017

dnetk

The cost of redeemable debt is calculated using an internal rate of return (IRR) approach.

The calculation takes the IRR of ◦ the annual net of tax interest payments from year

1 to year n, plus◦ the redemption payment in year n, minus◦ the original market value of the debt in year zero

In the case of convertible bonds, the redemption payment would become the market value at year n of the ordinary shares into which the debt is to be converted .

We may calculate MV in n year’s time using the model: nn gPP 10

Kpref = cost of preference shares d = annual dividend P0 = current ex-dividend market price

0P

dk pref

Proposition I◦ The market value of any entity is independent of its

capital structure and is given by capitalizing its expected return at the rate appropriate to its class.

◦ Vg = Vug

Proposition II◦ The expected yield of a share is equal to the

appropriate capitalization rate for a pure equity stream in the class, plus a premium related to financial risk equal to the debt-to equity ratio times the spread between the capitalisation rate and the interest rate on debt.

◦ Keg = keu + (D/E)×( keu – kd)

Proposition III◦ The cut-off point for investment in the entity will

in all cases be the average cost of capital and will be completely unaffected by the type of security used to finance the investment.

◦ WACCg = WACCug

Proposition I◦ Vg = Vug + TB ◦ TB = Present Value of Tax Shield

Proposition II◦keg = keu + [(1 – t)× (D/E)×( keu – kd)]

Proposition III◦ WACCg = WACCug × [1 – TB/(D+E)]◦ Or◦ WACCg = [keg× (E/(D+E)] + [kd× (1 –t)× (D(D+E)]