Question

In: Finance

Cost of Capital During the last few years, Harry Davis PVT Ltd (HDPL) has been too...

Cost of Capital
During the last few years, Harry Davis PVT Ltd (HDPL) has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that has been proposed by the marketing department. Assume that you are the company financial analyst. Your task is to estimate HDPL’s cost of capital. Finance manager of HDPL has provided you with the following data, which she believes may be relevant to your task.
A) Dividend just paid =$2.35
B) Expected dividend growth rate =5%
C) Current share price= $44
D) Beta of company ordinary share =0.87
E) Risk free rate of return =3.6%
F) Expected return on the market =11%
G) Capital structure is 75% equity and 25% Debt
H) Cost of debt = 5.8%
I) Company tax rate = 30%
Required
1. Calculate cost of equity using the dividend growth model. ​​​
2. Calculate cost of equity using the Capital asset pricing model (CAPM). ​​
3. Calculate WACC using cost of equity in 1 above (DGM) ​​​​
4. Calculate WACC using cost of equity in 2 above (CAPM) ​​​​
5. Compare and contrast the advantages and disadvantages of using dividend growth model (DGM) based cost of equity, and Capital Asset Pricing Model (CAPM) based cost of equity for determining the WACC?​​​​​​​​

Solutions

Expert Solution

Facts

D0=$2.35

g=5%

P0=$44

Beta =0.87

Rf =3.6%

Rm=11%

Debt Proportion = 25%

Equity Proportion = 75%

Kd=5.8%

Tax rate = 30%

Answer

1. Calculation of Cost of Equity (Re) using DGM

D1=D0(1+g) = $2.35(1.05)=$2.4675

Re=D1/P0 +g =$2.4675/$44+0.05 =0.1061 or 10.61%

2. Calculation of Cost of Equity (Ke) using CAPM

Ke= Rf+Beta*(Rm-Rf)

=3.6+0.87*(11-3.6)

=10.04%

3. WACC using DGM

Source Prportion Cost

Weighted Cost(Prop*Cost)

Equity 0.75 10.61 7.9575
Debt 0.25 4.06(5.8*(1-0.3)) 1.0150
WACC 8.9725

4.WACC using CAPM

Source Prportion Cost

Weighted Cost(Prop*Cost)

Equity 0.75 10.04 7.530
Debt 0.25 4.06(5.8*(1-0.3)) 1.015
WACC 8.545

5. Comparision of DGM vs CAPM

DGM CAPM
1.Ke 10.61% 10.04%
2.WACC 8.9725% 8.545%
3.Advantages It is easy to calculate and understand( NPV of future cash flows) Widely used by investor
4.Disadvantages

DGM can be used only for dividend

paying stocks. This model does not account for investment risk. Considers dividend in constant ratio.

Too many assumptions are involved.

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