BUSF_A01.qxd

Chapter 10 • Cost of capital estimations and the discount rate

If the first of these is adopted, a similar approach is taken to that for perpetual loan

notes, that is:

pE 0 = (10.3)

which, when all dividends are equal, means:

kE= (10.4)

If we assume a constant rate of growth (g), then:

pE 0 =+ + +... (to infinity) (10.5)

which reduces to:

pE 0 = (10.6)

so:

kE=+g (10.7)

where d 1 is the expected dividend per share, payable next year. This is known as the

Gordon growth model, after the person who derived it (Gordon 1959).

Tesco plc, in its 2007 annual report, stated that in estimating its cost of capital it

assumes an annual growth rate of 3 to 4 per cent.

McLaney, Pointon, Thomas and Tucker (2004) found that 28 per cent of listed UK

businesses use a dividend approach to estimating the cost of equity. Of these, 75 per

cent include a growth factor, almost always a rate of growth based on a past trend.

Al-Ali and Arkwright (2000) found that 21 per cent of larger UK businesses use the

dividend approach. Graham and Harvey (2001) found that 16 per cent of the US busi-

nesses surveyed use this approach, with smaller businesses more likely to adopt it than

larger ones. Note that CAPM has become the standard way to derive the cost of equity,

in practice. This is despite its severe weaknesses, which we discussed in Chapter 7.

d 1

pE 0

d 1

kE−g

d 1 (1 +g)^2

(1 +kE)^3

d 1 (1 +g)

(1 +kE)^2

d 1

1 +kE

dn

pE 0

dn

(1 +kE)n

∞

∑

n= 1

A business’s ordinary shares are currently trading at £2.00 (ex dividend) each in the capital

market. Next year’s dividend is expected to be £0.14 per share, and subsequent dividends

are expected to grow at an annual rate of 5 per cent of the previous year’s dividend. What

is the cost of equity?

Example 10.2

kE=+g

=+0.05

=12%

0.14

2.00

d 1

pE 0

Solution