Question

What is the definition of capital budgeting?

Select one:

a. Allocating the available capital amongst possible projects.

b. Ensuring that there is enough capital available to undertake all possible projects.

c. Making sure that there is surplus capital left over after all possible projects have been undertaken.

d. Both (a) and (b).

A share is expected to pay a dividend of $3.67 next year, and this dividend is expected to grow at the rate of 3% in perpetuity. If the current price of the share is $64.69, what is the cost of ordinary shares for the firm?

Select one:

a. 8.84%

b. 7.22%

c. 9.86%

d. 8.67%

Answer 1

Solution:

Definition of capital budgeting

Correct choice is 'a. Allocating the available capital amongst possible projects.'

Other choices are either incorrect or do not come as close to the definition since:

'b. Ensuring that there is enough capital available to undertake all possible projects.' Capital budgeting is not about ensuring availability of capital but rather more of a decision making process of which projects to take up and how to allocate or ration available capital (the capital is always a limited resource) among those projects that can be underatken feasibly. Ensuring there is enough capital avaialable is more of a financing decision and is not merely concerned with cost of capital but how efficiently and economically it can be raised while in capital budgeting the cost of capital is a given.

'c. Making sure that there is surplus capital left over after all possible projects have been undertaken.' Capital budgeting is not about making sure that there is surplus capital left over; it is not a residual concept but concentrates on the limited available capital which is why the need to allocate or ration capital arises.

'd. Both (a) and (b)' Since b is incorrect, this option is also incorrect.

Cost of ordinary shares of the firm, k_e

Correct option is d. 8.67%

Dividend expected per share next year, D₁ = $3.67 next year

Growth rate of dividend, g = 3% or 0.03

Current price of the share, P₀ = $64.69

According to Gordon's Growth Rate Model / Dividend Discount Model:

P₀ = D₁ / (k_e - g)

where P₀ is the price of the share at point of time 0 ,

D₁ is the expected dividend at year 1 (next year)

k_e is the cost of equity capital or ordinary shares

g is the perpetual growth rate of dividend

Substituting available values we have

$64.69 = $3.67 / (k_e - 0.03)

$64.69 x (k_e - 0.03) = $3.67 ..................(Multiply both sides by (k_e - 0.03))

k_e - 0.03 = $3.67 / $64.69 ....................(Divide both by 64.69)

k_e - 0.03 = 0.056732

k_e = 0.056732 + 0.03

k_e = 0.086732

k_e = 8.67%