Estimation of the Cost of Equity Capital Using Gordons Dividend Discount Model - Assignment Example

Estimation of the Cost of Equity Capital Using Gordon’s Dividend Discount Model School Affiliation Dividends of Australian Listed Companiesfrom Four Different Sectors 1. Travel & Leisure: Crown Resorts Limited 2. Infrastructure: Leington Holdings 3. Biotech: CSL Limited 4. Banking: ANZ Bank Yearly dividends received by Shareholders: Crown Resorts Limited (Adapted from Morningstar, Data Analysis Premium.) Balance Date Dividend Type Cent Per Share Interest Yearly 30/06/2014 Final 19.00   37.3591 30/06/2014 Interim 18.00 0.3591   30/06/2013 Final 19.00   37.3591 30/06/2013 Interim 18.00 0.3591   30/06/2012 Final 19.00   37.3591 30/06/2012 Interim 18.00 0.3591   30/06/2011 Final 19.00   37.3591 30/06/2011 Interim 18.00 0.3591   30/06/2010 Final 19.00   37.3591 30/06/2010 Interim 18.00 0.3591   30/06/2009 Final 19.00   37.3591 30/06/2009 Interim 18.00 0.3591   30/06/2008 Final 29.00   54.4988 30/06/2008 Interim 25.00 0.4988   30/06/2007 Final 25.00   55.5985 30/06/2007 Interim 30.00 0.5985   30/06/2006 Final 29.00   59.5985 30/06/2006 Interim 30.00 0.5985   30/06/2005 Final 25.00   52.5387 30/06/2005 Interim 27.00 0.5387   Leington Holdings (Adapted from Morningstar, Data Analysis Premium.) Balance Date Dividend Type Cent Per Share Interest Yearly 30/12/2014 Interim 57.00     30/12/2013 Final 60.00   105.8978 30/12/2013 Interim 45.00 0.89775   30/12/2012 Final 60.00   80.399 30/12/2012 Interim 20.00 0.399   30/12/2011 Final 60.00   121.197 30/06/2011 Interim 60.00 1.197   30/06/2010 Final 85.00   151.2968 30/06/2010 Interim 65.00 1.29675   30/06/2009 Final 55.00     30/06/2009 Interim 60.00 1.197 145.00 30/06/2008 Final 85.00     30/06/2008 Interim 60.00 1.197 125.00 30/06/2007 Final 65.00     30/06/2007 Interim 45.00 0.89775 86.00 30/06/2006 Final 41.00     30/06/2006 Interim 25.00 0.49875 55.00 30/06/2005 Final 30.00     30/06/2005 Interim 20.00 0.399   30/06/2004 Final 27.00   45.3591 30/06/2004 Interim 18.00 0.3591   CSL Limited (Adapted from Morningstar, Data Analysis Premium.) Balance Date Dividend Type Cent Per Share Interest Yearly 30/06/2014 Interim 53.00     30/06/2013 Final 52.00   102.9975 30/06/2013 Interim 50.00 0.9975   30/06/2012 Final 47.00   83.7182 30/06/2012 Interim 36.00 0.7182   30/06/2011 Final 45.00   80.6983 30/06/2011 Interim 35.00 0.69825   30/06/2010 Final 45.00   80.6983 30/06/2010 Interim 35.00 0.69825   30/06/2009 Final 40.00   70.5985 30/06/2009 Interim 30.00 0.5985   30/06/2008 Final 23.00   46.4589 30/06/2008 Interim 23.00 0.45885   30/06/2007 Final 55.00   104.9776 30/06/2007 Interim 49.00 0.97755   30/06/2006 Final 40.00   68.5586 30/06/2006 Interim 28.00 0.5586   30/06/2005 Final 30.00   74.5387 30/06/2005 Special Cash 10.00 0.1995   30/06/2005 Interim 17.00 0.33915   30/06/2004 Final 26.00   38.2394 30/06/2004 Interim 12.00 0.2394   NZ Bank (Adapted from Morningstar, Data Analysis Premium.) Balance Date Dividend Type Cent Per Share Interest Yearly 30/09/2014 Interim 83.00     30/09/2013 Final 91.00   165.45635 30/09/2013 Interim 73.00 1.4564   30/09/2012 Final 79.00   146.3167 30/09/2012 Interim 66.00 1.3167   30/09/2011 Final 76.00   141.27680 30/09/2011 Interim 64.00 1.2768   30/09/2010 Final 74.00   127.0374 30/09/2010 Interim 52.00 1.0374   30/09/2009 Final 56.00   102.91770 30/09/2009 Interim 46.00 0.9177   30/09/2008 Final 74.00   137.2369 30/09/2008 Interim 62.00 1.2369   30/09/2007 Final 74.00   137.23690 30/09/2007 Interim 62.00 1.2369   30/09/2006 Final 69.00   126.1172 30/09/2006 Interim 56.00 1.1172   30/09/2005 Final 59.00   111.01745 30/09/2005 Interim 51.00 1.0175   30/09/2004 Final 54.00   101.9377 30/09/2004 Interim 47.00 0.9377   Proxy Annual Constant Growth Rate of Dividends   Crown Resorts Limited Leington Holdings CSL Limited ANZ Bank year Dividend rate of change Dividend rate of change Dividend rate of change Dividend rate of change 2014 37.36 105.9 103.00 165.46 2013 37.36 0.00 80.4 0.32 83.72 0.23 146.32 0.13 2012 37.36 0.00 121.2 -0.34 80.70 0.04 141.28 0.04 2011 37.36 0.00 151.3 -0.20 80.70 0.00 127.04 0.11 2010 37.36 0.00 116.2 0.30 70.60 0.14 102.92 0.23 2009 37.36 0.00 146.2 -0.21 46.46 0.52 137.24 -0.25 2008 54.50 -0.31 110.9 0.32 104.98 -0.56 137.24 0.00 2007 55.60 -0.02 66.5 0.67 68.56 0.53 126.12 0.09 2006 59.6 -0.07 50.4 0.32 74.54 -0.08 111.02 0.14 2005 52.54 0.13 45.36 0.11 38.24 0.95 101.94 0.09 CGR (g) -0.03 0.14 0.20 0.06 Exp. D 2015 36.23 120.73 123.6 175.39 Expected Return on Equity Below are the closing Stocks as at 30/06/2014 for the four selected companies. (Adapted from www.yahoo.com.au/finance ) Crown Resorts Limited: 15.54 Leighton Holdings Ltd: 22.39 CSL Limited: 74.01 ANZ Banking Group: 33.45 Gordon,s model in estimating cost of Equity capital uses the formula Where; P – Current stock price g – Constant Growth Rate in perpetuity expected for the dividends r – Constant cost of equity for the company D1 – Annual dividend Applying the formula to the values obtained for the four companies, the result is as below, Crown Resorts Limited: r = -0.6% Leighton Holdings Ltd: 22.39 r= 19.39% CSL Limited: 74.01 r= 21.67% ANZ Banking Group: 33.45 D1 = 11.24% From the above results, we can observe that CSL Limited,a biotech company has the highest rate of return on equity at 21.67%. It is closely followed by the Infrastructure company Leighton Holdings at 19.39%, ANZ Banking group comes in third with 11.24% and crown resorts limited, a travel and leisure company has the least rate of return on equity at -0.6%. from the calculated yearly dividends, the first three companies show a gradual increase in the values while Crown resorts indicate a sharp decline before it stabilizes at a value below the dividend given in the first year of review. The expected return figures obtained for these four companies are justified as they reflect in part the general trend observed in the various sectors. Watson and Head (2007) suggests that Biotech companies are expected to incur high cost of initial investment in research but with time they record high returns owing to the sale of their innovative products. The findings concur with those of Brown et al, (2012) who further proposes that the high returns for pharmaceutical companies increase exponentially as the new product’s market reach increases. On the other hand, Construction companies can be termed as safe investments as they have less risk, since most of the capital for such companies is held up in assets (Boritz, 2006) and (Megginson, 1996). This sector has high returns on investment owing to the booming real estate industry in Australia. The banking sector is dependent on the country’s economy and income levels of the people as discussed by Mishkin and Eakins (2006). They state that since Australia is a developed country, over 90% of the people above 18 years of age operate bank accounts. With more people saving money with the banks, there is enough money to offer loans to businesses and individual thus making it a profitable sector. In contrast to this, the travel and leisure industry is highly affected with seasonal tourism experienced in Australia as reported in “An Introduction to Technical Analysis” (1999). Although most people may have disposable income to use in leisure, they prefer international destinations during seasons such as winter when the temperatures are very low. In addition, the competition in the sector, makes it a less profitable sector especially for small and medium companies. There are three major methodological setbacks associated with the Gordon’s growth model. Firstly, it is assumed that the growth rate is constant which might not necessarily be the case. Secondly, for stocks of growing companies, there may be no annual dividend in which case stock’s dividend is replaced by earnings per share therefore causing a difference with the value calculated from dividend. Additionally, in this method, stock price over-depends on the growth rate used. Two other methods employed in calculating cost of equity are the capital Asset Pricing Model (CAPM) and the P/E Model. The price earning valuation model is recommended in stocks for companies whose dividend payout is inconsistent and that are growing at an irregular rate (Kumar and Hyodo, 2011). Both the Gordon’s model and the P/E model have a basic formula of K = (D/P) + g, however while the Gordon’s model reflects fair value, P/E ratio on the other hand indicates the relative stock price. In order to show clearly how risky or safe a company is for investment, an integrated method like that in Gordon’s model is preferred as opposed to the ratio method of calculating stock value. The CAPM model requires that values are assigned to the risk free rate of return. For a project specific discount rate, the equity beta has to be treated as an average since proxy companies operate many business ventures. The method considers the sensitivity of assets to non-diversifiable risk together a theoretical free-risk asset’s rate of return (Easton, 2003). The assumption of a riskless asset is a disadvantage for this method. However its simplicity to use makes it a popular method of calculating rate of return on equity. Any of the three methods above can be used to calculate the cost of equity. The values obtained by use of either of the method may vary owing to a number of factors. To begin with, being a simple average, small companies will be weighted above their market proportion (Watson and Head, 2008). Besides that, analysts tend to give an upward bias as regards to estimates basing on market expectation. Basing on this argument, it is evident that the two methods CAPM and P/E model may in specific circumstances be better that the Gordon’s model depending on the size of the company, and the stability of its stocks. Bibliography An Introduction to Technical Analysis (1999). Singapore. John Wiley & Sons (Asia) Pte Ltd. Brown, A., Clarke, J., Howard, K. & Lim, P. (20012) Analysts dividend forecast. Pacific Basin Finance Journal 10 (4): 21 Boritz, J. (2006). Maintaining Quality Capital Markets through Quality Information. Capital Markets Leadership Task Force Discussion Paper. Easton, P. (2003). PE Ratios, PEG Ratios, and Estimating the Implied Expected Rate of Return on Equity Capital. University of Notre Dame. Mimeo. Kumar, S. & Hyodo, K. (2011) Price - earning ratio in Japan: recent evidence and further results. Megginson, W. Corporate Finance Theory, Addison-Wesley, p10, 1996. Mishkin, F. & Eakins, S. (2006) Financial Markets and Institutions 5th ed. USA. Pearson Prentice Hall. Watson, D. & Head, A. (2007), Corporate Finance: Principles and Practice, 4th ed, FT Prentice Hall, pp221–3. Watson, D. & Head, A. (2008), Project-specific discount rates, student accountant, pp252–3 Read More