Investment Analysis: Dividend Growth and SML

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Questions and Answers

What is a direct effect of an upward revision of the growth rate, g, by one percentage point on the estimated cost of equity?

It decreases the cost of equity by one percentage point.

It increases the cost of equity by at least one percentage point. (correct)

It increases the dividend payout ratio.

It has no effect on the cost of equity.

Which of the following does the SML approach explicitly adjust for?

Dividend changes

Risk (correct)

Operational costs

Market conditions

What two estimates are required when using the SML approach?

Risk-free rate and dividend growth rate

Expected return and dividend yield

Market risk premium and beta coefficient (correct)

Cost of debt and liabilities

What is the estimated market risk premium based on large common stocks?

7 percent Signup and view all the answers

In the context of cost of equity estimation, what does beta represent?

The individual stock's systematic risk Signup and view all the answers

Which of the following is a disadvantage of the SML approach?

It relies on accurate estimation of market risk premium and beta coefficient. Signup and view all the answers

What does the lack of adjustment for risk in certain approaches indicate about estimated returns?

They may not reflect the actual risk level. Signup and view all the answers

What does the cost of equity for Abercrombie & Fitch represent in context of SML approach?

13.05 percent Signup and view all the answers

What is the market risk premium based on?

Historical returns on stock portfolios and markets Signup and view all the answers

Why is the cost of debt generally easier to determine than the cost of equity?

It is directly observable through interest rates Signup and view all the answers

What can be a significant concern when using past data to predict future outcomes in finance?

Economic conditions can change quickly Signup and view all the answers

Which approach is NOT mentioned as a method to estimate the required return on debt?

Assessing the firm's overall capital structure Signup and view all the answers

What should be observed when determining the cost of debt?

The yield on the firm's existing bonds Signup and view all the answers

When might we gain more confidence in our cost estimates for equity?

When both the dividend growth model and SML yield similar outcomes Signup and view all the answers

Which of the following best defines the cost of preferred stock?

A dividend rate that is fixed and predictable Signup and view all the answers

What can potentially skew the estimation of market risk premium?

Using different stock portfolios or markets Signup and view all the answers

What does WACC represent in a firm?

The risk and target capital structure of its entire portfolio Signup and view all the answers

When is it appropriate to use WACC as a discount rate?

When the new project mirrors the firm's existing operations in terms of risk Signup and view all the answers

Why should WACC not be used for projects with significantly different risk profiles?

It may lead to lower project valuations Signup and view all the answers

What can be inferred about a project with a beta of 0.60 compared to a firm's beta of 1.0?

The project is considered less risky than average Signup and view all the answers

What factor is essential to consider when ensuring WACC reflects project risk?

A comparable alternative in financial markets with the same risk level Signup and view all the answers

What is a consequence of using an incorrect WACC for project evaluation?

Inaccurate assessment of project cash flows Signup and view all the answers

What does using market value weights for WACC indicate about its calculation?

It reflects the current risk perception in the market Signup and view all the answers

How does the Security Market Line (SML) relate to the WACC?

SML represents the risk-return trade-off for different investments Signup and view all the answers

Study Notes

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.

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Description

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.