Question

QUESTION 4: Cost of capital

4.1 XYZ Ltd has an equity beta of 1.30, market risk premium is expected to be 6%,
and the yield on government bonds is currently 9%. XYZ Ltd issued bonds (R100
par value) that are currently trading at R80 and have an 8% coupon rate. The
corporate tax rate is currently 28% and the maturity date of the bonds is in five
years.
Using the CAPM, calculate the cost of equity and the markets overall expected
rate of return (Rm). Thereafter, interpret these values.

4.2 XYZ Ltd paid a dividend of R0.15 per share and the dividend is expected to grow
at 9% annually. Currently, the share pr⁸ice is R1.50.

What is XYZ’s cost of equity based on the dividend growth model?

4.3 Considering your answers on the two questions above, discuss the main
differences between the CAPM and dividend growth model.

Answer 1

4.1

YTM = { Interest paid + (Face value - P rice)/time to maturity } / { (Face value + Price)/2 }

YTM = { 8 + (100-80)/5 } / { (100+80)/2 } = 13.333%

CAPM = Risk free rate + Beta * Market premium = 13.333% + 1.3*6% = 21.333%

4.2

The current market price of share = Dividend of next year/(Cost of equity - growth)

=> 1.5 = 0.15*1.09/(cost of equity - 0.09)

=> Cost of equity = 19.9%

4.3

The major difference is CAPM looks at the firm's risk i.e. beta of the stock whereas the dividend model focuses on Market price and the future cash flow in the form of dividends. So there is a difference in the cost of equity.