Question

*Parts A to D not included as they have been previously answered*

ABC Co. has the following dividend payment history for the last five years, with the most recent dividend being $3.60.

Dividend

$2.00

$2.50

$2.90

$3.20

$3.60

Dividend growth model

e. Given that ABC’s share price is currently $65, and the most recent dividend paid is $3.60 per share, use the three growth rates estimated for historical growth (compound growth rate, average year-to-year growth rate, and alternative estimate) to calculate the cost of equity using the dividend growth model. (3 marks)

f. Average the three estimated costs of equity in part (e). (1 mark)

SML model

g. Given that the firm’s equity beta is 1.6, the risk-free rate is 5%, and the expected return on the market index is 13.5%, calculate its cost of equity using the SML model. (1 mark)

WACC calculation

h. Calculate the firm’s average cost of equity by averaging the answers in parts (f) and (g). (1 mark)

i. ABC’s capital structure contains only debt and equity. Given that its debt-equity ratio is 0.8, its cost of debt is 10%, and its marginal tax rate is 35%, calculate the firm’s WACC using the cost of equity calculated in part (h). (2 marks)

NPV calculation

j. The firm has a project with an initial cost of $1 million, and annual cash savings of $300,000 for the next five years. The risk adjustment for this project on the WACC is +5%. Calculate the net present value of this project using the WACC calculated above. (4 marks)

k. Should the firm go ahead with the project? (1 mark)

Answer 1

e)						Price	Cost of equity
	Dividend	Growth rate		Avg growth	15.96%	65.00	22.38%
	$2.00			Compounded growth	15.83%	65.00	22.24%
	$2.50	25.00%		Alternative estimate	15.50%	65.00	21.90%
	$2.90	16.00%
	$3.20	10.34%
	$3.60	12.50%
f)	Average of cost of equity			22.17%
g)	Cost of equity			18.60%
h)	Avg cost of equity			20.39%
i)	Debt	44.44%	6.50%
	Equity	55.56%	20.39%
	WACC	14.22%
j)	NPV	($87,100.47)
k)	Since NPV is negative, so project should be rejected