Question

1. a) DERIVE THE "COST OF EQUITY" USING THE GORDON DIVIDEND MODEL FOR THE STOCK PRICE OF    £386, GROWTH IN DIVIDEND OF 3%, AND DIVIDEND OF £36.

THEN INDICATE WHETHER IS RETURN ON EQUITY IS A GOOD RETURN RELATIVE TO CURRENT YEAR 2012 RETURNS ON EQUITY WHICH HAVE BEEN RUNNING FROM 4 % TO 7 % FOR THRIVING MANUFACTURING CONGLOMERATES AND EVEN HIGHER FOR SOME VENTURE CAPITAL AND PRIVATE EQUITY FIRMS UPWARD TO OVER 10 %.

b) IS THE DISCOUNTING OF INVESTMENT VENTURE CASH FLOWS DEEPER WITH THE RATE YOU HAVE DERIVED, OR LESS THAN

Answer 1

a)

Cost of equity = It is the expected rate of return derived from the investment made or money invested in the firm or project.

In the given question Stock price is given £386 , growth rate is give 3% and dividend is £36.

Stock price is the present value of all discounted future benefits including their growth and its formula is as follows:

Stock price = Dividend / ( Cost of equity - Growth rate)

£386 =  £36 / ( Cost of equity - 0.03)

Cost of equity = (£36 / £386) + 0.03   

= 12.33%

Given that:

Current year 2012 return on equity for thriving manufacturing conglomerates is running between 4% to 7% and for venture capital and private equity firms return on equity is over 10% . This means in general market the return which is expected from the stock price is up to 10%. However this stock gives return of 12.33% which means it gives return more than expectation. Hence it is good return as compare to current year return on equity.  

b) As above mentioned return on equity is expected return on the amount invested. Hence higher the return higher the expectation of future benefits.

For deeper discounted cash flow investor has to lower the expected return to the market return. Hence return should be less than what we derived above ( i.e. 12.33%).

Lower rate of return on equity will leads to higher discounting of cash flow. Since cash flow derived from the venture investment become more than expected and increase their present value while discounting.

If rate of equity is higher than what than rate of return of market then cash flow given by market become lower than expected and discounted cash flow become lower.