CHAPTER 10

Determining the Cost of Capital

If you want to start a business, what kind
of decisions will you have to make?
Which business to start?
Where will the money to run the business
come from?
How do I manage the day-to-day
operations?
CHAPTER 10
Determining the Cost of Capital
A financial manager has to
make three types of decisions:
Capital Budgeting
Capital Structure
Cash Budgeting
Capital Budgeting
Should the firm invest in a project or fixed
asset?
Does acquiring that asset make financial sense?
Are the benefits of the assets over its life greater
than its costs?
Capital Structure
How should that project be financed?
What mix of debt/common stock/preferred stock to
use?
Cash Budgeting
The day-to-day running of business.
Inventory management, credit management, etc.

Capital Budgeting
Estimate the cash flows of the project.
Estimate the cost of capital.
Use one or more capital budgeting techniques
to evaluate the project (NPV, IRR, etc.).

Capital budgeting decision depends on cost of
capital.
Cost of capital depends on capital structure.

Cost of Capital
Capital
Budget
Capital
Structure
Your capital structure will tell you how much debt, equity and preferred stock you are going
to use to fund your long term assets.
That composition tells you your cost of capital.
An analysis of projects/assetss benefits versus the cost of money (capital) to acquire it,
enables you to make the capital budgeting decisions.
Capital budgeting decisions tells you how much money you need to run your business. Does
it also tell you your capital structure?
If not, then where does that recipe of how much debt, equity and preferred stock to have in
your business soup come from?

Suppose your firm has an optimal capital structure it
wants to maintain.
That is, the firm has a recipe in mind before it starts
cooking instead of randomly adding any ingredients it
can lay its hands on.
This is a target capital structure that the firm wants to
maintain in the long run.
In the short run the firm might deviate from it.
Why?
Well, many possible reasons.
The firm might want to time its issue of debt or
equity.
Each issue of shares and bonds has to be of a certain
minimum size because of the transaction costs.

Lets take things to the baby formula level.
What is a capital structure?
It is the composition of long term funding
sources the firm is going to use.
What are long term funding sources?
What is long term?
Long term is more than a year. If somebody gives
you money to run your business and you can
keep the money for more than one year, it is your
long term source of money or long term
capital.

True or false?
Inventory is a long term source of capital.
False.
Inventory is what you spend money on, not what
gives you money. (Unless you have an inventory
of trees that grow money instead of leaves.)
Notes payable is a long term source of capital.
False.
At least it is a way for you to get money for your
business so the source of capital part is
correct.
But it is not long term in nature. You have to pay
back the notes payable within a year.
Now the composition part.
How much total capital will you have if you
were to tell me in percentage?
100%
Capital structure tells you what part of that
100% will come from long term debt, equity
and preferred stock.
Are we now clear about that one sentence
we saw a few slides ago?
Capital structure is the composition of long
term funding sources the firm is going to
use.

Right way of expressing a capital structure or wrong?
My firm has 50% debt, 40% equity and 20% preferred stock and thats my
firms capital structure.
Wrong. Why?
50%+40%+20%= 110%
My firm has 50% debt, 40% equity and 10% preferred stock and thats my
firms capital structure.
Right
My firm has 30% debt, 70% equity and thats my firms capital structure.
Right
But it does not tell us anything about the preferred stock.
Wrong. It does.
It tells you, the firm has no preferred stock in its capital structure.
Did I say, you have to have all three?
Can you have 0% long term debt?
Of course you can.
Can you have 0% equity?
In your dreams.

Lets summarize what we learnt so far.
What types of long-term capital do firms
use?
Long-term debt
Preferred stock
Common equity
Capital structure tells the weight
(percentage) of each of these parts in
your total capital (sum of all three
sources).
Weighted Average Cost of Capital
(WACC)
The idea is extremely simple.
Find the cost of each component
Find the weight of each component
(the percentage of funds coming
from each source).
Multiply the weights by respective
costs and add all of them up.
Weighted Average Cost of Capital (WACC)
Weight of long tem debt * after tax cost of long term debt
+
Weight of equity * after tax cost of equity
+
Weight of preferred stock * after tax cost of preferred stock

Which of the above will be not be a percentage?
All of the above numbers will be percentages.
What is that after tax confusing addition here? You will
know in a few minutes.
Weighted Average Cost of Capital (WACC)
Lets call the weights ws, for example, so
the weight of debt will be w
d
, and the cost r,
so the cost of debt will be r
d
.

Why r? Why not c?
Because for the people giving you the
money, it is return, their required rate of
return for giving you the money.
Weighted Average Cost of Capital
(WACC)
WACC = w
e
* after tax r
e
+ w
d
* after
tax r
d
+ w
ps
* after tax r
ps

We will deal with that after tax issue
in a minute.
Weighted Average Cost of Capital (WACC)
So far, things are pretty straight
forward, or so I think.
Remember, two things before going
forward:
The costs of each component has to
be after tax
If flotation costs are significant, they
have to be incorporated.
Weighted Average Cost of Capital (WACC)
What are flotation costs, you ask?
It is the cost of issuing new securities, like paying
your investment bankers, cost of producing and
filing documents with SEC, the cost or producing
brochures, etc. (remember, the cost is not the cost
of printing and paper alone, it is mostly the cost of
paying experts to do that work and is therefore, a
very substantial amount).
If suppose, you could issue one share for $100 but
it costs you $2 per share to be able to sell it
(flotation cost), your net cash inflow is $98, not
$100 per share.
We will discuss how to incorporate the flotation
cost for each component of long term capital as we
go along.
Weighted Average Cost of Capital
(WACC)
Now, what makes the practice of
calculating WACC not that simple?
The costs have to be future costs (or
marginal costs) not historic costs.
The weights should come from not
the current level of debt and equity
but the target capital structure.
The calculations should be based on
market values, not book values.
Should we focus on before-tax or
after-tax capital costs?
Tax effects associated with financing
can be incorporated either in capital
budgeting cash flows or in cost of
capital.
Most firms incorporate tax effects in
the cost of capital. Therefore, focus
on after-tax costs.
Only cost of debt is affected.
After-tax Cost of Debt
Suppose your earnings before interest
and taxes are $200. Your interest
payment is $100 and your tax rate is
40%.
What will happen if interest payment
was the same thing as dividend
payment from IRSs point of view?
How much money will you have left to
pay your shareholders or keep inside
the firm?
After-tax Cost of Debt
EBIT 200
Tax 80
EBI 120
Interest 100
NI 20
Now imagine IRS rules allow tax deductibility of interest payments (the way
things are in real life).
EBIT 200
Interest 100
EBT 100
Tax 40
NI 60
So how much did you save because of tax deductibility of interest payments?
$40
Which is the same amount as interest*tax.
So your real out of pocket cost of debt is not the full interest amount, you
have to deduct the tax savings from it.
After tax cost of debt = interest interest*tax = interest(1-tax)
9 - 22
Weighted Average Cost of Capital
(WACC)
WACC = w
e
*r
e
+ w
d
*r
d
*(1-tax rate)+ w
ps
*r
ps

A very simple example
Assume the following:




Tax Rate = 40%
What is the WACC?
11.6%
Now, lets tackle the issue of estimating individual
costs.
Source Cost Weight
Long term Debt 10% 30%
Preferred Stock 8% 10%
Common Stock 15% 60%
Cost of Debt
Method 1: Ask an investment banker
what the coupon rate would be on
new debt.
Method 2: Find the bond rating for
the company and use the yield on
other bonds with a similar rating.
Method 3: Find the yield on the
companys debt, if it has any.
Cost of Debt
What if I find the coupon rate on the bond that company sold two
years ago and it has not matured yet?
Can I just use the coupon rate of that bond?
After all, it is the bond of company I need to know the
information for, right?
Besides, the bond is still alive and well.
The answer?
No.
Why?
The coupon rate tells you which rate people required from your
debt when you issued it as a new bond.
Thats two years ago. Thats history.
What people require for new bonds now, might or might not be
the same return.
If you want to use the existing bond data, the correct number is
the yield to maturity (YTM) on that bond, not the coupon rate.
How come YTM is not a dead/old number? It is coming from the
same two year old bond, isnt it?
Cost of Debt

Do you know why YTM is better?
Suppose you issued the bond last year with 5% coupon rate.
At the time of issue, people bought it at the face value ($1,000).
Ever since then the interest rate on similar new bonds has gone up to 6%.
If your bond is a regular bond, its coupon will be fixed.
Who would like to buy your bond which gives 5% coupon when the new
ones are giving 6%?

Does that mean, there is no way to sell your 5% bond?

Sure there is, people will buy it but at a lower price than original $1,000.

When people buy the bond at a price lower than the face value, they make
money two ways:
The 5% coupon rate + the money they make by buying it at less than par
(less than $1000) and then getting the par or face value back at maturity
(capital gain)

How low should the price be?
Low enough that over the life of the bond:
Coupon rate + capital gains yield = 6% = Yield to maturity
Cost of Debt


Thus, the yield to maturity tells you the prevailing
required rate of return on debt not the old one. It
involves the current market price of the bond which
adjusts as the interest rates change in the market.


Coupon rate tells you the old rate and the world has
moved away from it.


How will things work if the new rate in the market is
lower than the coupon rate you set on your bond last
year?
A 15-year, 12% semiannual bond sells
for $1,153.72. Whats r
d
?
60 60 + 1,000 60
0 1 2 30
i = ?
-1,153.72
...
A 15-year, 12% semiannual bond sells for $1,153.72.
Whats r
d
?
Use Excel function called RATE.
For a semi-annual bond, convert everything except the
market price and face value into six-months terms.
That is,
The coupon payments will be halved and time
periods will be doubled.
The face value is your fv (future value), the market
value is your pv (present value), nper is number of
payments, pmt is your coupon payment.
You pay the price so enter the market price as a
negative number.
=RATE(nper,pmt,-pv,fv)

The answer will be in six-months terms, multiply it by
2 to get annual yield.
A 15-year, 12% semiannual bond sells for $1,153.72. Whats r
d
?
Bond Cell name or formula
Face Value $ 1,000.00 E10
Market Price $(1,153.72) E11
Time to Maturity 15 years E12
Number of Periods per year 2 E13
Total Number of Periods 30 E13*E12
Coupon Rate 12% paid semiannually E15
Coupon Payment $ 60.00 per six months E10*E15/2
Yield to maturity 5.00% per six months RATE(E14,E16,E11,E10)
Yield to maturity (annual) 10.00% E17*E13
Component Cost of Debt
Interest is tax deductible, so the after tax (AT)
cost of debt is:
r
d AT
= r
d BT
(1 - T)
= 10%(1 - 0.40) = 6%.
Use nominal rate.
Flotation costs small, so ignore.
But, if you want to adjust for flotation cost, use
the price net of flotation cost when calculating
ytm and use the resulting higher number as r
d

before tax.
Whats the cost of preferred stock?
P
P
= $113.10; 10%Q; Par = $100; F = $2.
n
ps
ps
P
D
r
Preferred stock pays you same dividend every period and
has traditionally no maturity (it lives forever).
There are now types of preferreds that do get taken out of
the market within a certain period of time but lets ignore
those for now.
What do you call something that gives you same amount of
money every period and never dies?
Perpetuity
The formula for finding the cost of preferred stock is the
same as the one you know for finding the rate of return on a
perpetuity, that is dividend (the dollar amount you get from
preferred stock every year) divided by the price of the
preferred now.

Whats the cost of preferred stock?
P
P
= $113.10; 10%Q; Par = $100; F = $2.

%. 0 . 9 090 . 0
10 . 111 $
10 $
00 . 2 $ 10 . 113 $
100 $ 1 . 0

n
ps
ps
P
D
r
Use this formula:
Picture of Preferred
2.50 2.50
0 1 2
r
ps
= ?
-111.1

...
2.50
.
50 . 2 $
10 . 111 $
Per Per
Q
r r
D

%. 9 ) 4 %( 25 . 2 %; 25 . 2
10 . 111 $
50 . 2 $
) (

Nom ps Per
r r
Note:
Flotation costs for preferred are
significant, so are reflected. Use
net price (net of flotation costs).
Preferred dividends are not
deductible, so no tax adjustment.
Just r
ps
.
Nominal r
ps
is used.
Directly, by issuing new shares of
common stock.
Indirectly, by reinvesting earnings
that are not paid out as dividends
(i.e., retaining earnings).
What are the two ways that companies
can raise common equity?
Earnings can be reinvested or paid
out as dividends.
Investors could buy other securities,
earn a return.
Thus, there is an opportunity cost if
earnings are reinvested.
Why is there a cost for reinvested
earnings?
Opportunity cost: The return
stockholders could earn on
alternative investments of equal
risk.
They could buy similar stocks
and earn r
s
, or company could
repurchase its own stock and
earn r
s
. So, r
s
, is the cost of
reinvested earnings and it is the
cost of equity.
Three ways to determine the
cost of equity, r
s
:
1. CAPM: r
s
= r
RF
+ (r
M
- r
RF
)b
= r
RF
+ (RP
M
)b.
2. DCF: r
s
= D
1
/P
0
+ g.
3. Own-Bond-Yield-Plus-Risk
Premium:
r
s
= r
d
+ RP.
Whats the cost of equity
based on the CAPM?
r
RF
= 7%, RP
M
= 6%, b = 1.2.
r
s
= r
RF
+ (r
M
- r
RF
)b.
= 7.0% + (6.0%)1.2 = 14.2%.
Issues in Using CAPM
Most analysts use the rate on a long-term
(10 to 20 years) government bond as an
estimate of r
RF
. For a current estimate, go
to www.bloomberg.com, select U.S.
Treasuries from the section on the left
under the heading Market.
Or, http://finance.yahoo.com/ . Choose,
Rates from under the Bonds heading from
the menu on the left.
More
Issues in Using CAPM (Continued)
Three possible ways to calculate
market risk premium:
Use historic market risk premium
R
f
R
S&P500
from past data
Adjust the historic market risk
premium subjectively
Apply DCF method to S&P500 index
to get E(R
M
) and calculate R
f
E(R
M
)
Issues in Using CAPM (Continued)
Most analysts use a rate of 5% to 6.5%
for the market risk premium (RP
M
)

Estimates of beta vary, and estimates
are noisy (they have a wide
confidence interval). For an estimate
of beta, go to www.bloomberg.com
and enter the ticker symbol for STOCK
QUOTES.
Whats the DCF cost of equity, r
s
?
Given: D
0
= $4.19;P
0
= $50; g = 5%.

g
P
g D
g
P
D
r
s

0
0
0
1
1

$4. .
$50
.
. .
.
19 105
0 05
0 088 0 05
13 8%.
Estimating the Growth Rate
Use the historical growth rate if you
believe the future will be like the
past.
Obtain analysts estimates: Value
Line, Zacks, Yahoo!.Finance.
Use the earnings retention model,
illustrated on next slide.
Suppose the company has been
earning 15% on equity (ROE = 15%)
and retaining 35% (dividend payout
= 65%), and this situation is
expected to continue.

Whats the expected future g?
Retention growth rate:

g = ROE(Retention rate)

g = 0.35(15%) = 5.25%.

This is close to g = 5% given earlier.
Think of bank account paying 15% with
retention ratio = 0. What is g of
account balance? If retention ratio is
100%, what is g?
Could DCF methodology be applied
if g is not constant?
YES, nonconstant g stocks are
expected to have constant g at
some point, generally in 5 to 10
years.
But calculations get complicated.
See Ch 9 Tool Kit.xls.
Find r
s
using the own-bond-yield-
plus-risk-premium method.
(r
d
= 10%, RP = 4%.)
This RP CAPM RP
M
.
Produces ballpark estimate of r
s
.
Useful check.
r
s
= r
d
+ RP
= 10.0% + 4.0% = 14.0%
Whats a reasonable final estimate
of r
s?
Method Estimate
CAPM 14.2%
DCF 13.8%
r
d
+ RP 14.0%
Average 14.0%

Determining the Weights for the WACC
The weights are the percentages of
the firm that will be financed by each
component.
If possible, always use the target
weights for the percentages of the
firm that will be financed with the
various types of capital.
Estimating Weights for the
Capital Structure
If you dont know the targets, it is
better to estimate the weights using
current market values than current
book values. (market capital
structure)
If you dont know the market value of
debt, then it is usually reasonable to
use the book values of debt,
especially if the debt is short-term.
(More...)
Estimating Weights (Market Capital Structure)
Suppose the stock price is $50, there are 3
million shares of stock, the firm has $25
million of preferred stock, and 100,000 long
term semi-annual coupon bonds outstanding
with a 15% annual coupon rate, 50 years left to
maturity and yield to maturity of 20%.
Find the market price per bond, if it is not
given already.
Multiply that price with the number of bonds
outstanding to get the market value of debt.
Same rule applies to preferred stock and
common stock.
Use the market values of each components to
find the capital structure weights.
V
ce
= $50 (3 million) = $150 million.
V
ps
= $25 million.
V
d
= $750*100,00 = 75 million.
Total value = $150 + $25 + $75 = $250
million.
w
ce
= $150/$250 = 0.6
w
ps
= $25/$250 = 0.1
w
d
= $75/$250 = 0.3
Whats the WACC?
WACC = w
d
r
d
(1 - T) + w
ps
r
ps
+ w
ce
r
s

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4% = 11.1%.
WACC
Weight of debt Weight of preferred Weight of equity
WACC
Weight of debt Weight of preferred Weight of equity
After-tax Cost of Debt
WACC
Weight of debt Weight of preferred Weight of equity
After-tax Cost of Debt
Ask Investment Banker
WACC
Weight of debt Weight of preferred Weight of equity
After-tax Cost of Debt
Ask Investment Banker
Use the rate of new bonds
with similar rating
WACC
Weight of debt Weight of preferred Weight of equity
After-tax Cost of Debt
Ask Investment Banker
Use the rate of new bonds
with similar rating
Find the yield to maturity
on companys existing bond
WACC
Weight of debt Weight of preferred Weight of equity
After-tax Cost of Debt Cost of Preferred
Ask Investment Banker
Use the rate of new bonds
with similar rating
Find the yield to maturity
on companys existing bond
Use the perpetuity formula
WACC
Weight of debt Weight of preferred Weight of equity
After-tax Cost of Debt Cost of Preferred Cost of Equity
Ask Investment Banker
Use the rate of new bonds
with similar rating
Find the yield to maturity
on companys existing bond
Use the perpetuity formula CAPM
WACC
Weight of debt Weight of preferred Weight of equity
After-tax Cost of Debt Cost of Preferred Cost of Equity
Ask Investment Banker
Use the rate of new bonds
with similar rating
Find the yield to maturity
on companys existing bond
Use the perpetuity formula CAPM
DCF
WACC
Weight of debt Weight of preferred Weight of equity
After-tax Cost of Debt Cost of Preferred Cost of Equity
Ask Investment Banker
Use the rate of new bonds
with similar rating
Find the yield to maturity
on companys existing bond
Use the perpetuity formula CAPM
DCF
Own bond + risk premium
Cost of Equity
CAPM
Rf + b (Risk Premium)
DCF
D1/P0 + g
Own Bond Yield+
Risk Premium
Risk free Rate Growth Rate
Find bond yield the
same way as
for the
Cost of debt
Do not use historic
Try to pick
the same maturity
T-Bond as the project
Some argue,
equity is long term
So pick the
longest maturity
T-Bond rate for Rf
Historical Growth
Rate
Beta Risk Premium
Regress historical
firms returns
Against
market returns
Monthly returns
Four to five years of
data
S&P 500 for market
proxy
Adjusted Beta
Fundamental Beta
Historical Risk
Premium
Forward-looking
Risk Premium
Forward looking
Risk free rate
Apply DCF
method on
S&P 500
to get expected
Return on market
IBES, Value Line
(Costs money)
Use Expected
Earnings
Growth Rate
for Dividend
Growth (Free)
Make subjective
Adjustment to historic
value
Retention Growth
Model
G = ROE*Retention Ratio
Analysts Forecasts
Risk Premium
is not the
Market risk
premium for CAPM.
It is subjective.
9 - 66
How can WACC change?
WACC =
W
e
*r
e
+ W
d
*r
d
*(1-T) + W
ps
*r
ps
w
d
w
ps
w
e
r
d
r
ps
r
e
YTM on existing bond D
PS
/P
PS
R
f
+ b*(Risk Premium)
D
1
/P
0
+ g
Own bond + risk premium
G = ROE * Retention Policy
9 - 67
How can WACC change?
WACC =
W
e
*r
e
+ W
d
*r
d
*(1-T) + W
ps
*r
ps
w
d
w
ps
w
e
r
d
r
ps
r
e
YTM on existing bond D
PS
/P
PS
R
f
+ b*(Risk Premium)
D
1
/P
0
+ g
Own bond + risk premium
G = ROE * Retention Policy
Controllable Factors:
Capital Structure
Dividend Policy
Investment Policy
Uncontrollable Factors:
Interest Rates
Tax Rates
Market Risk Premium
Should the company use the
composite WACC as the hurdle rate for
each of its divisions?
NO! The composite WACC reflects the
risk of an average project undertaken
by the firm.
Different divisions may have different
risks. The divisions WACC should be
adjusted to reflect the divisions risk
and capital structure.
Estimate the cost of capital that the
division would have if it were a stand-
alone firm.
This requires estimating the divisions
beta, cost of debt, and capital structure.
Make subjective adjustment to firms
WACC.
If the projects is riskier than the firm as a
whole, increase WACC (add points to it).
If it is safer, reduce the firm-wide WACC
(subtract points from it).
Risk-adjusted cost of capital for a particular division that has a
level of risk different from the overall risk of the firm.
Methods for Estimating Beta for a Division or a Project
1. Pure play. Find several publicly traded
companies exclusively in projects business.
Use average of their betas as proxy for
projects beta.
Hard to find such companies.
2. Accounting beta. Run regression between
projects ROA and S&P index ROA.
Accounting betas are correlated (0.5 0.6)
with market betas.
But normally cant get data on new projects
ROAs before the capital budgeting decision
has been made.

Is the division
or the project
just as risky as
the firm
as a whole?
Yes No
Use firms
WACC
Make
subjective
adjustment
Find New WACC
Riskier
project/
division
Safer project/
division

Increase WACC,
Add
percentage points
Decrease WACC,
Subtract
percentage points
Cost of debt:
Mostly the
same the firm.

Cost of preferred:
Mostly the
same the firm.

Cost of Equity
DCF? No.
Project does not
give separate dividends

Own bond yield + Risk Premium?
Same thing as increasing
or decreasing WACC
CAPM?
Yes.
New risk free rate?
No.
New market
risk premium?
No.
New beta?
Yes.
Pure Play
Accounting beta
Find the divisions market risk and cost
of capital based on the CAPM, given
these inputs:
Target debt ratio = 10%.
r
d
= 12%.
r
RF
= 7%.
Tax rate = 40%.
beta
Division
= 1.7.
Market risk premium = 6%.
Beta = 1.7, so division has more market
risk than average.
Divisions required return on equity:
r
s
= r
RF
+ (r
M
r
RF
)b
Div.

= 7% + (6%)1.7 = 17.2%.
WACC
Div.
= w
d
r
d
(1 T) + w
c
r
s

= 0.1(12%)(0.6) + 0.9(17.2%)
= 16.2%.
How does the divisions WACC
compare with the firms overall WACC?
Division WACC = 16.2% versus
company WACC = 11.1%.
Typical projects within this division
would be accepted if their returns are
above 16.2%.
What are the three types of project
risk?
Stand-alone risk
Corporate risk
Market risk
How is each type of risk used?
Stand-alone risk is easiest to
calculate.
Market risk is theoretically best in
most situations.
However, creditors, customers,
suppliers, and employees are more
affected by corporate risk.
Therefore, corporate risk is also
relevant.
A Project-Specific, Risk-Adjusted
Cost of Capital
Start by calculating a divisional cost
of capital.
Estimate the risk of the project using
the techniques in Chapter 12.
Use judgment to scale up or down
the cost of capital for an individual
project relative to the divisional cost
of capital.
Using DCF method for non-constant growth
DCF method only applies when the
growth is constant starting next
period.
What happens when growth changes
in the first few years?
Using DCF method for non-constant growth
Suppose Acme Inc. just paid a $5
dividend. That dividend is expected
to grow by 10% next year, 15% for
the two following years, 10% for the
year after that and then grow at 5%
thereafter. If the cost of equity is
20%, what is the current price of
Acmes share?
Using DCF method for non-constant growth
Always make a timeline and put your numbers under
the respective year.
Growth rates 10% 15% 15% 10% 5%
Time 0 1 2 3 4 5
Dividends 5 5.5 6.325 7.274 8.001 8.401

Should we go on calculating the dividends?
Where do you see constant growth in front of you?
All the dividends starting from the year with constant growth till eternity
will be captured by one number, the horizon value or constant growth
value, as long as:
Growth is constant (does not have to be positive)
Growth is less than the required rate of return on equity, or the discount
rate.
Horizon Value formula for any time t = (Dividend at time t+1)/(R
constant growth rate).
Now we can take care of all dividends from 8.401 till eternity at year 4.
Using DCF method for non-constant growth
Always make a timeline and put your numbers under the respective year.
Growth rates 10% 15% 15% 10% 5%
Time 0 1 2 3 4 5
Dividends 5 5.5 6.325 7.274 8.001 8.401
Horizon value 8.401/(.20-.05)
Horizon value 56.008
Total cash flow at each year:
5.5 6.325 7.274 64.009
Present value of cash flows:
4.58 4.39 4.21 30.8686
Share price now (at time zero) = 4.58+4.39+4.21+30.8686
= $44.054

Important: The zero period dividend never gets added to the price. We wrote it here in the
beginning just to help us forecast the period 1 dividend. After that was done, period zeros
dividends job was done and it can now go into retirement.