The Cost of Capital : Impact of Globalisation

a)

b)

The dividends of Qantas Airways, BHP Billiton, and Coca-Cola Amatil have been derived from the financial database. All the interim dividends of the company are appropriately annualized before adding up with final year-end dividends to determine the actual value of annual dividends received by the shareholders. The interim dividend is the amount of money that a company pays before the preparation of financial statements. The dividends paid by Qantas Airways was in the year 2006 to 2008 ad after that the company has not paid the dividend (Helbæk, Lindest and McLellan, 2010).  The dividend paid by BHP Billiton has increased from the year 2006 to 2015. In 2016, the dividend of the company decreased. The dividend paid by Coca-Cola Amatil has also increased from the year 2006 to 2016. The dividend paid by the companies shows the ability of the firm to generate returns on the invested capital. The dividends are paid at the end of the first half of the year, and the companies are earning six months of interests at the risk-free rate for next half. The risk-free rate is the rate of return on an investment having zero risks. It represents the interest that would be expected from a risk-free investment (Elliott and Elliott, 2008). The companies will pay dividends for the first half of the year in which the company will earn interest at the risk-free rate for next half. The bonds rate of the Australian government is 1.92%. It is very much important for the companies to earn maximum profits to generate returns for the investors. The risk-free rate shows the risk level of the businesses and ability to pay the dividends at minimum risk. All the interim dividends should be annualized appropriately before adding up with year final dividend to determine the actual dollar value of the yearly dividends.                                                                                             

c)

The dividend payment history of Qantas Airways, BHP Billiton, and Coca-Cola Amatil shows the real position of the companies in the current market. The annual constant growth rate of dividends is used in Gordon’s model to predict the next year’s dollar dividend value. The dividend growth rate is the percentage growth rate that a dividend of stock undergoes over a period (Holton, 2012). The dividend received by the shareholders has been determined and evaluated of past ten years. The constant growth model will help to predict next year’s dollar dividend value. The main aim of predicting the future dividend growth is to estimate the overall development of the company. The shareholders also get returns on the invested capital which means they are very much concerned about the dividend growth of the business (Kieso, Weygandt and Warfield, 2007).         

d)

The closing price of Qantas Airways, BHP Billiton Limited and Coca-Cola Amatil has been derived and evaluated. The Gordon’s model will help to estimate the expected return on equity for each of the stock. Gordon Growth Model is also known as dividend discount model is the method to calculate the intrinsic value of the stock exclusive of the current market conditions (Moles, 2011). It allows the investors to estimate the value of the share of the stock. The model also helps to compare the organizations in different industries which make the model one of the most widely used valuation tools and equity analysis. It is believed that growth model of Gordon exclusion of the nondividend factors undervalues the stocks in organizations with customer loyalty, brand names, other non-dividend and unique intellectual property (Spiceland, Sepe and Nelson, 2011). The two circumstances that make the Gordon more efficient is that a company should distribute dividends and second is that the growth rate of dividend cannot exceed the required rate of a retro of the investors. 

The expected return of Qantas Airways has decreased in comparison to previous year. It shows that value of expected return has decreased which means the performance of the company has dropped. Qantas Airways has become the largest international and domestic airline in Australia and considered as the strongest brand and long distance airline in Australia. The overall market condition for the airline industry is quite favorable. It provides wide opportunities for airline companies to grow in the current market (Spiceland, Sepe and Nelson, 2011). The airline industry is developing in a faster way as well as competition is also increasing. The expected return of Qantas Airways has decreased which shows a negative result for the company. Therefore it is very much important for the company to take adequate steps to increase the rate of return.

The expected return of BHP Billiton Limited has also decreased over the period. The value of expected return has reduced in comparison to previous year. BHP Billiton is a leading global resource company. The primary purpose of the company is to create long-term value for the shareholders through acquisition, discovery, marketing and development of natural resources. The market condition is quite favorable that has led to the elaboration of the company (Spiceland, Sepe and Nelson, 2011). The industry provides a wide opportunity for BHP Billiton and has become the world’s largest manufacturer of primary commodities which includes metallurgical coal, uranium, copper, iron ore, energy coal and unconventional gas and oil. The expected return value has decreased which shows a negative result for the company.

The planned return of Coca-Cola Amatil has decreased over the period. Coca-Cola Amatil is one of the favorite brands for soft drink customers. The company provides a quality product to their clients. The market conditions are quite favorable and considered as one of the growing and largest industry in the country (Wolf, 2008). The expected rate of return of Coca-Cola Amatil has decreased which shows a negative result for the company. Therefore, it is important for the company to take adequate steps to enhance its performance.

e)

As per the assumption of the Gordon’s Growth Model, the cost of equity is found out with a positive dividend payout at a constant rate over a period in the future which can be predicted. The precondition of this model is that the growth rate is stable and steady when the calculation is being carried out. But as per the observations, there are only a few stocks in the market that show such characteristics (Armitage, 2005). With the information given in the above data, it can very easily be understood that at most of the time, the stocks are not consistent and stable and tend to vary a lot from time to time. This is the exact matter of concern in the case of Gordon’s model because as per Gordon’s growth model the assumption is that the dividends grow at a constant rate but in the case of a situation here the rate is less than that of the required return. It will not be applicable. The fact is that growth rate will not always be less than the cost of capital, and therefore it will be very much unreasonable to assume such a situation and condition. Moreover, this particular model will not be able to estimate or calculate stocks a negative dividend growth rate (Hardouvelis, Malliaropulos and Priestley, 2004). Another problem with the methodology of Gordon’s Model is that the formula makes an assumption for a single constant growth rate for dividends. But as the case is in the real world, the dividend growth most certainly changes from time to time for many different kinds of reasons. Therefore the assumptions made by Gordon’s Model hardly apply in the real world where the dividends do not grow at a constant rate and also there are times when the growth rate of the dividends is more than the required cost of capital (Witmer, 2008). Therefore the cost of equity when measured through Gordon’s Model will not be able to yield the correct and proper answers as the two primary conditions of the dividends not growing at a constant rate, and the growth rate of the dividends being more than the required cost of the capital will not be met with. Another factor that comes into play is that of the condition of a foreseeable future, and this is quite tight. Each and every business organization in the world is always busy preparing for new strategies to cope up with changes and problems that may occur abruptly in the future, and the main reason behind that is all the happenings of the future are quite unpredictable (Pratt and Grabowski, 2008). Therefore it would be foolish to assume that for a period in the future there would be no change of rate in the growth of dividends and that no such situation will arise where the growth of the dividends is much more than the required cost of the capital. These are the main methodological problems associated with the Gordon Model.

Gordon’s growth model helps in assuming the cost of the equity which is known for the creation of the positive dividend payout at the constant rate over the futures. The precondition also helps in the creation of the condition that helps in the creation of the characteristics which are seemed to be stable and consistent during the time (Gordon, 2016). In addition to the Gordon Model, two basic stock evaluation equations are Zero-growth Model and the Variable-growth model.

The Zero-growth Model also helps in the creation of the approach to dividend valuations assuming the constant non-rowing dividend stream. The Zero-growth in the case of the dividends helps in the creation of the values of the shares that are seemed to be helpful for the representation of perpetuity of the dividends at the discounted rate. The Zero-growth Model provides the following derivations that are represented as follows:-

With the usage of the property of infinite series the model can be seemed to be reduced, if g=0

With the usage of this model, the assumptions that can be seen are that the growth rate in dividends is constant, the earnings per share are consistent, and the payout ratio is constant (Anon, 2016).  The present value of the stock is also represented with the consideration of no-growth formula and is also seemed to be more conceptual with the implementation of the every circumstance. The general idea of the stock can be implemented with the creation of the investment in the case of the stock based on the future cash flows. The analytics and the investors help in the formulation of the future cash flows with the considering the essential factors with the consideration of the dividends (Aswath, 2016). The investors and the analytics also provide the appreciation of the stock with thereby the considerations are made for the expected future earnings and henceforth the overall economy can be determined.

The variable growth model provides the definition of the dividend valuation approach with the incorporation of the changes in the growth rate of the dividend. With the assumptions of the initial growth rate and the growth rate that occurs at the end of the year, the share values can be determined quickly. With the creation of relation to the Gordon’s Growth Model, the expectations on the earnings help in the creation of the return in the two ways that can be defined as the dividends and the capital gains (Damodaran, 2016). The perception had created a positive impact on the creation of opportunity.

However, Gordon’s model of equity cost estimation is most modern and efficient growth model, which provide a proper evaluation of the growth rates of investment over the time, there are few issues can be seen in the Gordon Model. Gordon Growth model presumes that the cost of stock or equity is familiar with an optimistic or positive dividend payout at a contentious degree over the predictable future (Fabozzi, Focardi and Kolm, 2006). Moreover, in Gordon’s model, there is a predetermined condition that the rate of growth is stable as well as steady, which is often alters in practical situations. Thus, the economists often use several different models for determining the cost of equity. Besides this, it is perceived that other two fundamental investment assessment equation, which delivers more accurate estimation are zero growth model and variable growth model (Grandes, Panigo and Pasquini, 2010). In the model of Gordon’s equity cost estimation r-g must be positive meaning so that in the case of the cost of capital is assumed to be lower comparative to the growth rate in the short term then usually a two steps of dividend discount model is utilized. 

A multi-steps dividend discount models to greater flexibility for the calculation of future profits stream. It also permits sensitivity testing as well as adjust the reactions from the market in a changing situation.  The zero growth model can be alternative to the Gordon growth model of equity estimation. As the zero growth model presume that the dividend forever stays at the same rate, the equity price may be same to the yearly dividends divided by the needed price of return (Ma, Sajadfar and Campos Triana, 2014).

Stock’s intrinsic value = Annual dividend / required rate of return

This is normally the similar formula utilized to compute the value of perpetuity, which is like a bond that never matures as well as may be utilized to rate preferred equity that makes payment of the dividend that is stipulated percentages of the stocks per value (Pratt, Grabowski and Pratt, 2011). Stock by zero growth models may remain to alter in price in case the capitalization rate changes. As it will be observed the rate changes, for example, in the event of a preferred equity share of a stock makes payment as a dividend of $1.80 / year, as well as the needed rate of return for the investment is 8% then the intrinsic value would be:

Intrinsic value of preferred stock = $1.80/0.08 = $ 22.50

As the zero growth rate, DDM is more efficient to compute the better equity cost estimation. Therefore it can be used to calculate investment cost estimate instead of Gordon growth rate model.

References

Armitage, S. (2005). The cost of capital. New York: Cambridge University Press.

Hardouvelis, G., Malliaropulos, D. and Priestley, R. (2004). The impact of globalization on the equity cost of capital. London: Centre for Economic Policy Research.

Pratt, S. and Grabowski, R. (2008). Cost of capital. Hoboken, N.J.: John Wiley & Sons.

Witmer, J. (2008). The cost of equity in Canada. Ottawa, Ont.: Bank of Canada.

Anon, (2016). [online] Available at: http://wps.aw.com/wps/media/objects/5449/5579779/VariableGrowthModel.pdf [Accessed 19 Aug. 2016].

Aswath, D. (2016). [online] Available at: http://people.stern.nyu.edu/adamodar/pdfiles/ddm.pdf [Accessed 19 Aug. 2016].

Damodaran, A. (2016). [online] Available at: http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/ddm.pdf [Accessed 19 Aug. 2016].

Gordon, M. (2016). [online] Available at: https://www.wiso.uni-hamburg.de/fileadmin/sozialoekonomie/bwl/bassen/Lehre/International_Finance_I/Assignments/1959_Gordon.pdf [Accessed 19 Aug. 2016].

Fabozzi, F., Focardi, S. and Kolm, P. (2006). Financial modeling of the equity market. Hoboken, N.J.: Wiley.

Grandes, M., Panigo, D. and Pasquini, R. (2010). On the estimation of the cost of equity in Latin America. Emerging Markets Review, 11(4), pp.373-389.

Ma, Y., Sajadfar, N. and Campos Triana, L. (2014). A Feature-Based Semantic Model for Automatic Product Cost Estimation. IJET, 6(2), pp.109-113.

Pratt, S., Grabowski, R. and Pratt, S. (2011). Cost of capital, fourth edition, workbook and technical supplement. Hoboken, N.J.: John Wiley & Sons Inc.

Elliott, B. and Elliott, J. (2008). Financial accounting and reporting. Harlow: Financial Times Prentice Hall.

Helbæk, M., Lindest, S. and McLellan, B. (2010). Corporate finance. New York: McGraw-Hill.

Holton, R. (2012). Global finance. Abingdon, Oxon: Routledge.

Kieso, D., Weygandt, J. and Warfield, T. (2007). Intermediate accounting. Hoboken, NJ: Wiley.

Moles, P. (2011). Corporate finance. Hoboken, N.J.: Wiley.

Spiceland, J., Sepe, J. and Nelson, M. (2011). Intermediate accounting. New York: McGraw-Hill Irwin.

Wilcox, M. and Wilcox, M. (2013). Accounts. London: Bloomsbury.

Wolf, M. (2008). Fixing global finance. Baltimore, Md.: Johns Hopkins University Press.

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