Question

Typically the cost of capital for a growth firm is higher than that of a mature firm, although a mature firm pays dividends, while a growth firm does not. Explain this apparent anomaly using the DCF formula. Clearly indicate the impact of dividend payment (mature firm) versus the absence of dividends (growth firm) in your analysis.

Answer 1

Answer-

Cost of capital for growth firm

The primary reasons for the high cost of capital for a growth firm are

1) The growth firms in general have to raise debt from Venture capital (VC) firms when investing in risky projects and the VCs required return is high and the cost of capital used to discount the cash flows is high. The growth companies are unable to raise loans from banks as the risk involved is high and  approval of loans from banks are difficult.

2) The high leverage for the growth companies increases the cost of equity as the required return on equity increases with debt as the risk premium required by equity holders increases the cost of capital or Weighted average cost of capital (WACC).

WACC (or) Cost of capital = Wt of equity x cost of equity + Wt of debt x cost of debt x ( 1 - tax rate)

We can see that from the above formula that the cost of equity increases the cost of capital or WACC.

As the growth firms does not have stable cash flows and paying dividends is not preferred by management as the income generated is reinvested in the projects which will help in expansion.
Eventhough the dividends are not paid but the investors prefer growth companies stocks a the growth rate is higher which will offset the dividends if paid .
Investors in general do not value companies by DCF method because they do not pay dividends but they are valued by Free cash flow of firm (FCFF) or Free cash flow Equity (FCFE).  

Cost of capital for mature firm

The cost of capital for mature firm is lower than that of growth firm as the mature firms have stable growth and the debt can be raised via banks and other financial institutions which have low interest rates.
The equity raised will also be low as the risk involved in investments is low due to collaterals provided by mature firms.
Therefore the cost of capital for mature firms is lower as compared to growth firms.

The mature firms which regularly pay dividends, these cash flows are discounted by WACC to get the present value

The DCF

PV = CF1 / ( 1+r) + CF2 / ( 1+r)2 + CF3 / (1+r)3  + ---- + CFn / (1+r)n

CF = cash flow
r = WACC or cost of capital
PV = Present value

The dividend payments paid by mature firms lowers the reinvestmets as the mature firms are stable. They have higher cash flows than growth firms which gives them the ability to pay regular diidends to investors which investors prefer as they needs regular returs on their investment.