Cost of capital

Question 1

Cost of equity

Answer 1

The minimum return that
shareholders require from the funds they have invested in the company

Question 2

Methods of estimating the cost of equity

Answer 2

Dividend valuation model
CAPM

Question 3

DVM pros and cons

Answer 3

Based on market data
vs
Assumes unrealistic constant dividend growth
Model falls if g > kₑ
Assumes that worth for shareholders is only represented by dividends

Question 4

Earnings retention model

Answer 4

g = rb
Growth in future dividends = current accounting rate of return (PAT / opening net assets) x % of profits retained

Question 5

Earnings retention model cons

Answer 5

Relies on accounting profits
Assumes r and b are constant
ARR can be distorted by inflation
Assumes all new finance comes from equity

Question 6

Cost of preference shares

Answer 6

Constant annual dividend / ex-div market value