Investment Analysis: Dividend Growth and SML

Dividend Growth Model

• Increasing the growth rate (g) by 1% can increase the estimated cost of equity by at least 1%
• Growth in dividends likely leads to an upward revision of the cost of equity
• The model doesn't explicitly consider risk, providing no adjustment for the uncertainty surrounding the growth rate.

Security Market Line (SML) Approach

• Required return for a risky investment depends on the risk-free rate (Rf), market risk premium (E(RM) - Rf), and the systematic risk of the asset (beta coefficient, β)
• The SML equation for expected return on equity (E(RE)) is: E(RE) = Rf + βE * (E(RM) - Rf)
• Using the SML, the required return on equity (RE) can be calculated as: RE = Rf + βE * (RM - Rf)

Implementing the SML Approach

• Requires: risk-free rate (Rf), market risk premium (RM - Rf), and the beta coefficient (βE)
• Using the SML, the cost of equity for Abercrombie & Fitch is estimated to be 13.05%
• The market risk premium is estimated to be 7%
• The risk-free rate is assumed to be 0.10%
• Beta coefficients for publicly traded companies are commonly available

Advantages and Disadvantages of the SML Approach

• Advantages:
  • Explicitly adjusts for risk
  • Applicable to companies with or without steady dividend growth
• Disadvantages:
  • Requires estimating market risk premium and beta coefficient
  • Estimates may be inaccurate
  • Relies on historical data, which may be unreliable to predict future economic conditions

The Cost of Debt

• Cost of debt is the return creditors demand on new borrowing
• Cost of debt can be observed directly (interest rate on new borrowing) or indirectly (yield to maturity on existing bonds)
• The coupon rate on outstanding debt is not the cost of debt, as it reflects historical cost at the time of issuance
• Cost of debt is represented by RD

The Cost of Preferred Stock

• Determining the cost of preferred stock is straightforward
• Cost of preferred stock is represented by Rp.
• Rp = Dp/Pp, where Dp is the dividend and Pp is the preferred share price
• Rp is not adjusted for taxes as preferred dividends are not tax-deductible.

WACC and Project Risk

• It is important to use WACC that reflects the appropriate risk level of the project when using it to discount cash flows
• Projects with similar risk levels belong to the same risk class
• WACC represents the risk and target capital structure of the firm's entire asset portfolio, not just a single project.

Appropriate Discount Rate

• WACC can be used as the discount rate only if a project has similar risk to the firm's existing operations.
• A project with different risk requires adjusting the WACC or using a separate discount rate.

The SML and the WACC

• WACC represents a firm's overall cost of capital, reflecting its average risk.
• However, WACC may be unsuitable for projects with significantly different risks from the company's average risk.
• Using the same WACC for projects with different risk than the company's average can lead to incorrect decisions.
• Using the SML can provide better guidance in such cases.

Explore the concepts of the Dividend Growth Model and the Security Market Line (SML) approach in this quiz. Learn how changes in growth rates affect the cost of equity and how to implement the SML for investment analysis. Test your knowledge on calculating required returns and understanding market risks.