Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VI. Cost of Capital and Long−Term Financial Policy

15. Cost of Capital © The McGraw−Hill^525
    Companies, 2002

Notice that we calculated the change in the dividend on a year-to-year basis and then ex-
pressed the change as a percentage. Thus, in 1999 for example, the dividend rose from
$1.10to $1.20, an increase of $.10. This represents a $.10/1.109.09% increase.
If we average the four growth rates, the result is (9.0912.503.7010.71)/4 
9%, so we could use this as an estimate for the expected growth rate, g.There are other,
more sophisticated, statistical techniques that could be used, but they all amount to us-
ing past dividend growth to predict future dividend growth.

Advantages and Disadvantages of the Approach The primary advantage of the
dividend growth model approach is its simplicity. It is both easy to understand and easy
to use. There are a number of associated practical problems and disadvantages.
First and foremost, the dividend growth model is obviously only applicable to com-
panies that pay dividends. This means that the approach is useless in many cases. Fur-
thermore, even for companies that do pay dividends, the key underlying assumption is
that the dividend grows at a constant rate. As our previous example illustrates, this will
never be exactlythe case. More generally, the model is really only applicable to cases in
which reasonably steady growth is likely to occur.
A second problem is that the estimated cost of equity is very sensitive to the esti-
mated growth rate. For a given stock price, an upward revision of gby just one percent-
age point, for example, increases the estimated cost of equity by at least a full
percentage point. Because D 1 will probably be revised upwards as well, the increase will
actually be somewhat larger than that.
Finally, this approach really does not explicitly consider risk. Unlike the SML ap-
proach (which we consider next), there is no direct adjustment for the riskiness of the in-
vestment. For example, there is no allowance for the degree of certainty or uncertainty
surrounding the estimated growth rate for dividends. As a result, it is difficult to say
whether or not the estimated return is commensurate with the level of risk.^3

The SML Approach

In Chapter 13, we discussed the security market line, or SML. Our primary conclusion
was that the required or expected return on a risky investment depends on three things:

1. The risk-free rate, Rf


2. The market risk premium, E(RM)
   Rf


3. The systematic risk of the asset relative to average, which we called its beta
   coefficient,

Using the SML, we can write the expected return on the company’s equity, E(RE), as:

E(RE) Rf

E[E(RM) 
Rf]

where (^) Eis the estimated beta. To make the SML approach consistent with the dividend
growth model, we will drop the Es denoting expectations and henceforth write the re-
quired return from the SML, RE, as:
RERf (^) E(RM
Rf) [15.2]
CHAPTER 15 Cost of Capital 497
(^3) There in an implicit adjustment for risk because the current stock price is used. All other things being equal,
the higher the risk, the lower is the stock price. Further, the lower the stock price, the greater is the cost of
equity, again assuming all the other information is the same.