Question

Aurizon Holdings (AH) is a publicly listed rail freight company in Australia. The current share price of AH is $4.80 per share. AH has 111 million shares outstanding, $55 million in debt, and $14 million in cash. AH plans to pay $0.25 per share in dividends in the coming year and the dividends are expected to grow by 3% per year in the future. AH’s long-term debt consists of bonds issued with a face value of $55 million with 10 years to maturity with annual coupon rate of 6% (APR). The long-term bonds are currently trading at par value. The beta of AH is 1.11, the risk-free rate is 2%, and the required return on the market portfolio is 6%. The corporate tax rate is 30%.

A. What is the AH’s cost of equity based on dividend discount model (DDM)? What is the associated dividend yield and capital gain yield?

B. What is the AH’s cost of equity based on capital asset pricing model (CAPM)?

C. What would the growth rate in DDM has to be in order to reach the same consensus as CAPM?

D. What is the AH’s after-tax cost of debt?

E. Using the average cost of equity obtained using DDM and CAPM in part (a) and

(b) above, calculate AH’s weighted average cost of capital (WACC)?

Answer 1

A)	Based on DDM
	Value of stock = Expected dividend per share/ (Cost of equity - Dividend growth rate)
	4.80 = .25 / (Cost of equity - .03)
	Cost of Equity = (.25/4.80 ) + .03
	Cost of Equity = 8.21 %
	Dividend yield = dividend/current stock price
	Dividend yield = .25/4.80
	Dividend yield = 5.21 %
	Capital gain yield = (Stock price after one year - Current stock price)/Current stock price
	Capital gain yield = (5- 4.80)/4.80
	Capital gain yield = 4.17 %
	*Assumed as stock price after one year as $ 5
B)	Based on CAPM
	Cost of equity = Risk free rate of return + (Market rate of return - Risk free rate of return ) Beta
	Cost of equity = 2% + (6% - 2%) 1.11
	Cost of equity = 6.44 %
C)	At 1.232 % growth rate (using trial and error method) cost of equity under CAPM and DDM will
	be same.
D)	Cost of debt = Rate of interest (1-tax rate)
	Cost of debt = 6% (1-.30)
	Cost of debt = 4.2 %
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