Question

Kingston Limited intends raising finance for a proposed new project. The financial manager has provided the following information to determine the present cost of capital to the company:

The capital structure consists of the following:

¦ 4 million ordinary shares issued at R4 each but currently trading at R6 each.

¦ 3 million 12%, R4 preference shares which incurred floatation costs of R0.16 per share.

¦ R4 000 000 15% Bank loan, due in July 2027.

Additional information

¦ The company’s beta coefficient is 1.5.

¦ The risk-free rate is 10%.

¦ The return on the market is 25%.

¦ A dividend growth of 10% per annum on ordinary shares was maintained over the past five years. The latest dividend paid was 150 cents per share.

¦ Assume that the company tax rate is 28%.

Cost of equity using the Capital Asset Pricing Model

Answer 1

The cost of equity using the CAPM can be calculated by substituting the risk-free rate, beta coefficient, and market return into the formula: Cost of Equity = Risk-Free Rate + Beta x (Market Return - Risk-Free Rate). In this case, the cost of equity for Kingston Limited is 32.5%.

Step-by-step explanation:

The cost of equity using the Capital Asset Pricing Model (CAPM) can be calculated using the following formula:

Cost of Equity = Risk-Free Rate + Beta x (Market Return - Risk-Free Rate)

Given that the risk-free rate is 10%, the company's beta coefficient is 1.5, and the market return is 25%, we can substitute these values into the formula:

Cost of Equity = 10% + 1.5 x (25% - 10%) = 10% + 1.5 x 15% = 10% + 22.5% = 32.5%

Therefore, the cost of equity for Kingston Limited is 32.5%.

The cost of equity represents the compensation the market demands in exchange for owning the asset and bearing the risk. In CAPM (Capital Asset Pricing Model), the cost of equity is calculated by adding the bond yield (Risk-free rate) to the product of the equity's beta and the market risk premium (Bond yield plus risk premium). However, in the DCF (Discounted Cash Flow) model, the cost of equity is calculated by discounting the expected future dividends or expected future cash flows of the company.

Without information on the company's cash flows, dividends, or beta, it is difficult to provide a best estimate for the firm's cost of equity. Regardless, the firm's cost of equity is an essential component of financial analysis and decision-making.