The Dividend Capitalization Model - Essay Example

Facilitator Cost of Equity Dividend capitalization model is used to come up with the formula for cost of equity (COE). The value of the company cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing risk of ownership. In this model the cost of equity is calculated using the following formula: Cost of Equity = Dividends per Share (of next year)/current market value of stock) + (growth rate of dividend). For Woolworths Limited Company, the dividend per share for next year was 71 (Woolworth Limited Annual Report 2013, pg. 48) with growth rate of 14.51 % (calculation: changed from 62 to 71). The price of Woolworths Limited company share can be calculated by formula: P= D [1] (r-g) where D [1] is the next dividend= 81 (from expected growth using current growth rate of 14.51%). P is the stock= 81* 9.91-0.1451 giving as price of share at 793.39.Substituting the figures into the formula; Cost of Equity = (71/793.39) + 0.1451 =23.45% Therefore, this is to mean that Woolworth limited company paid as compensation 6.3 to the market demand in exchange owning the assets, which have the risks of ownership. It is a widely used formula by most companies for assurance purpose, to those who buy shares of those particular companies for risk taking. Cost of Debt A keen and a thoughtful look on the Woolworth limited company annual report is suggestive that they have massive risks. By natural law of commerce, the riskier the business or the company the higher the cost of debt. The company uses various bonds, and loans and other form of debts that in turn give insights the rate of being paid by company to use debt financing. The cost of debt is usually calculated by a simple multiplication of the credits before tax rate by one minus marginal tax. ([CREDITS BEFORE TAX RATE] Of [1-MARGINAL TAX]) So in this segment borrowing of Woolworth will be considered in coming up with the cost of the debt of the company. Borrowing here are stated at amortized cost with the difference between the cost and redemption value recognized in a collected income over a period of borrowing. Consolidated cash flow statement of Woolworth limited company the amortization of borrowing costs was 3491.6 (Woolworth Limited Annual Report 2013, pg. 162)while the marginal tax for the company was in the range of 30 % (Woolworth Limited Annual Report 2013, pg. 48). Substituting into the formula; Cost of debt = (3491.6) of (1-30%) = 2444.12 Cost of Capital This are the overall cost for financing a company like Woolworth limited. The mode of financing usually plays a pivotal role in determining the cost of capital. Financing can be done in two ways to a company or a combination of both. The two modes are: cost of equity and cost of debt. For the case of Woolworth, it used equity and debt to finance the company. The overall cost of capital for this case is arrived at from weighted average of all capital sources. This is known as weighted average cost of capital. The cost of capital here represent the hardship that Woolworth has to overcome before it said its generating value. It is here that the investors find reason as to whether they should proceed with the project or not. Weighted average cost of capital (WACC) is calculated as follows: WACC = E/V *Re + D/V* Rd* (1-Tc) Where; Re= cost of equity = 23.45 % (Refer calculation above) Rd= cost of debt = 2444.12 (Refer calculation above) E= market value of firms equity = 9300.5 (Woolworth Limited Annual Report 2013, pg. 112) D =market value of firms debt = 2719.9 (Woolworth Limited Annual report 2013, pg. 112) V = E + D = 9300.5+2719.9= 12092.4 E/V = percentage of financing that equity = 93005/12092.9=7.69 D/V = percentage of financing that debt = 2719.9/12092.9=0.22 T.c. = corporate tax rate = 30 % (Woolworth Limited Annual report 2013, pg. 48). Substituting into the formula; WACC= 7.69* 0.2345 + 0.22 * 2444.12* (1-0.3) = 378.20 Cost of capital with future of company It is used in making investment decision of the company. For the case of Woolworth limited company with cost of capital of 72 called for more investment. This is possible because cost of capital is used as discount factor in determine net. In addition, the actual rate of return is compared cost of capital. For Woolworth limited it was worthwhile investing more. Capital structure The proportion of debt and equity constitute the capital structure. The two can help in coming up with optimum capital structure. This is the proportion that can maximize the cost of capital and maximize the value of firm. Here the value of each source of financing is put into consideration. This means it was worthwhile business to move on with the project since it does not incur huge sourcing from external. Capital Asset Pricing Model (CAPM) In any business there are two thing involved in relation with the securities. CAMP is a model that describe these things. They are risk and expected return. The two are used to price any risky securities. Is from this that the basis of compensating the investors is dawn from. The following formula is used to calculate: Ra= Rf + Ba+ (rm-Rf) Where; Ra = total compensation the investor is given for taking risk Rf = Risk free rate (represent the time value of money) =2242.1/12,713 (Woolworth Limited Annual Report 2013, pg. 209) *100=17.64% Ba = Beta of security (risk measure) = 0.4796 for Australian economy. Rm = Expected market return = 2242.1 (Woolworth limited company annual report, 2013 pg. 209) From this model, it’s said that the expected return of security equals the rate on a risk free security plus. Substituting above: the investors in Woolworth limited company will expect compensation of 14955.40 Dividend Growth Model This segment in company is designed to solve one of the complex part of a company. It’s used to evaluate the equity that the shareholder in Woolworth limited company ought to have. It involves a number of activities such as knowledge of the company( Woolworth limited), forecasting of its performance, selection of proper valuation model and other complexities as discussed by the major team players. This model has assumptions in which it operates on one is that the dividend growth rate is constant, two is that the growth rate cannot equal or supersede the required rate of return and three is that the investors required rate of return is both known and constant. The formula used is: P = D/k-g Where: P = security\s price; D = dividend payout ratio = dividend/net income = 71/12713 = 0.006 k = required rate of return = 0.49 (derived from the capital asset pricing model) g=dividends expected growth rate = 14.51 %. Substituting above, the security price for investors in Woolworth Company is 0.017 that is 1.7% Comparison of dividend growth and capital asset pricing model Comparably, I will pick on capital asset pricing model and drop on dividend growth capital. The reason is based on the premise of its assumptions which do not favor Woolworth limited company. The first assumption is only practical to those company that do not pay the dividend of (Woolworth limited usually pays dividend). In addition, the dividend growth model do not deal with the risk directly as it ought to. Because this is the major interest of the investor. In contrast, CAPM operate on broader spectrum and with restrictive assumption. The only condition in CAPM is that the share of Woolworth limited company is quoted in the stock exchange. Reference Woolworth Limited. Woolworths Limited Annual Report 2013. Annual Report. New South Wales: Woolworths Limited, 2013. Document. Read More