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Homework answers / question archive / Indigo Pte Ltd, a company operating in the retail clothing industry, is an all equity company
Indigo Pte Ltd, a company operating in the retail clothing industry, is an all equity company. When the company was launched on the London Stock Exchange, management issued 20 million $1 shares. Over the past years, annual dividends per share have been as follows:
Dividends year (cents)
Two years ago 24.94
Last year 26.20
Current year 27.50
Management has announced that the rate of growth in dividend payments is expected to continue into the foreseeable future. The beta value for the retail clothing industry has been estimated at 1.25 and the risk-free rate of interest and the expected return on the market portfolio are currently 4% and 12% respectively.
Required:
(a) Discuss the relevance of the cost of equity for listed companies like Indigo Pte Ltd (4 marks)
(b) Calculate the fundamental value of Indigo’s equity. (6 marks)
(c) Eagle Pte Ltd operates in the tourism industry. It plans to pay dividends of £10m next year. Dividends are expected to grow at a rate of 5% per year forever. The current market value of Eagle Pte Ltd is $100m. What is your best estimate of Eagle’s equity beta? (6 marks)
(d) Discuss the strengths and drawbacks of two models of calculating the cost of equity. (9 marks)
Part (a)
Cost of equity is an indicator of return required by the investors to invest in that particular equity. It's not directly observable in the market, and hence the same has to be calculated or estimated. Hence, the relevance of the cost of equity for listed companies like Indigo is to quantify the return required by the investors and make the market participants aware of the riskiness of the equity cash flows of the company.
Part (b)
g = CAGR in dividend = (D2/D0)1/2 - 1 = (27.50 / 24.94)1/2 - 1 = 5.00%
Div next year = D = D2 x (1 + g) = 27.50 x (1 + 5%) = 28.88
Cost of equity, Ke (using CAPM) = Rf + beta x (RM - Rf) = 4% + 1.25 x (12% - 4%) = 14%
the fundamental value of Indigo’s equity per share = P = D / (Ke - g) = 28.88 / (14% - 5%) = 321.10
Hence, the value of total equity = P x N = 321.10 x 20 million = $ 6,422.07 million
Part (c)
best estimate of Eagle’s equity (using the Gordon Growth Model) = Ke = D1/P0 + g = 10/100 + 5% = 15%
Ke = Rf + Beta x (Rm - Rf)
Or, 15% = 4% + beta x (12% - 4%)
Hence, best estimate of Eagle’s equity beta = (15% - 4%) / (12% - 4%) = 1.375
Part (d)
| Parameter | CAPM Method | Gordon Growth Method |
| Strengths |
Simple, easy to apply, easy to comprehend Straight forward |
Acounts for the riskiness of the investment through beta Appicable for all companies irrespective of their dividend payment history and dividend growth rates |
| Weaknesses |
You need to forecast next year's dividend Not relevant for non dividend paying stock Assumes dividend grow @ a constant rate forever, this usually doesn't hold true in real life Doesn't explicitly consider the riskiness of the investment |
Each component of CAPM (Rf, beta and Rm) are estimates. Hence, in order to estimate one parameter, you end up estimating three parameters CAPM relies on historical performance; may not be a good indicator of future performance |
