AFMP4
Syllabus B3cd. The Cost of CapitalCost of equity

Dividend Valuation Model 1 / 5

The cost of equity – the dividend growth model

DVM can be with or without growth.

What this means is that the share price can be calculated assuming a growth in dividends or not

Essentially this model presumes that a share price is the PV of all future dividends. Calculate this (with or without growth) and multiply it by the total number of shares

It is similar to market capitalisation except it doesn’t use the market share price, rather one worked out using DVM

  1. DVM (without growth)

    The share price is calculated like this:

    • Constant Dividend / Cost of Equity (decimal)

      Cost of Equity will be given, or calculated via CAPM

      Take this share price and multiply it by the number of shares

  2. DVM with growth

    • Dividend in year 1 / Cost of Equity - growth (decimal)

      Or

    • Dividend just paid (1+g) / Cost of Equity - growth (decimal)

Illustration

  • Share Capital (50c) $2 million
    Dividend per share (just paid) 24c
    Dividend paid four years ago 15.25c
    Current market return = 15%
    Risk free rate = 8%
    Equity beta 0.8

Solution

Dividend is growing so use DVM with growth model:

  • Calculating Growth 

    Growth not given so have to calculate by extrapolating past dividends as before:

    24/15.25 sq root to power of 4 = 1.12 = 12%
    So Dividend at end of year 1 = 24 x 1.12

  • Calculate Cost of Equity (using CAPM) 

    8 + 0.8 (15-8) = 13.6%

    Share price = 24x1.12 / 0.136 - 0.12 = 1,680c
    Market cap = $16.8 x (2m / 0.5) = $67.2