Question

A. The dividend growth model has been used by Investor Ltd, an investment advisory company, to value the Australian share market. In January this year, the company assumed that the historic dividend yield of 4% per annum, the normal cost of equity capital of 7% per annum and the long-term dividend growth rate of 2.5% per annum would continue for the Australian share market for many years to come. However, several months later, due to the effects of the coronavirus pandemic and falling oil prices, the market had fallen by 25%. On the assumption that the dividend yield and the dividend growth rate did not alter over this period, what change in the costof the Australian equity capital would induce this drop in share prices of 25%?

Answer 1

Assuming dividend yield of 4%, we take $4 as dividend.

The dividend growth model states that:

Price = Dividend*(1+dividend growth rate) / (Cost of equity - Divident growth Rate)

At the starting of the year, the price of the Australian market is:

{$4 * (1+2.5%)} / {7% - 2.5%} = $91.11

Folowing a 25% decline in the price, the new price is = 91.11*0.75 = $68.3325

To derive the new cost of equity, we have to plug the numbers at their respective position in formula:

68.3325 = {$4 * (1+2.5%)} / {New cost of equity - 2.5%}

{New cost of equity - 2.5%} = {$4 * (1+2.5%)} / 68.3325

{New cost of equity - 2.5%} = 6%

New Cost of equity = 6% + 2.5% = 8.5%