How do you calculate a company’s cost of equity?

How do you calculate a company’s cost of equity?
How do you calculate a company’s cost of equity? Derivative contracts can magnify the impact of underlying movements in asset values, creating large gains or extreme losses. Two types of derivatives have been implicated as being part of the reason for the 2008 financial crisis.
  • Name the two derivatives in question and describe how, and why, their contracts originate. (6 marks)
  • Conduct an internet search into the UK and US governments’ responses to the 2008 financial crisis and their attempts to prevent a similar crisis happening again.
    • Name the UK and US acts that were brought into law in response to the crisis. (2 marks)
    • Outline the new regulatory authorities, and their responsibilities, that were brought into existence by the UK. (5 marks)
    • Describe what is meant by ‘ring-fencing’ retail banks and how this protects bank customers.
  • Both put and call options can be traded on wheat futures. The current strike price of 3-month wheat is $204 for both options. The put option costs $5.10 per ton and the call option is $5.95 per ton.
    • At the 3-month date, wheat is trading at $212.05. Which option would be exercised? Calculate the payoff and gain for the put option. What is the gain for the call option compared to the market price?
    • Calculate the payoff and gain for the put option and the gain/(loss) for the call option if the price of wheat at the 3-month date is $197.80.

iii.At what prices would the two options be price neutral?



What are the best ways to derive the cost of equity?


The information below is available about a 15-year fixed coupon bond issued by Pure Air Plc and the market.

Face value £100
Current market price £120
Annual coupon rate 4%
Prevailing interest rate 3%
    • Compute the semi-annual coupons for this bond.
    • Given the information above, is the price of the bond likely to increase or decrease in the future? Justify your answer and also calculate the new price.
    • Emma is one of the major bondholders of Pure Air Plc, owning 45% of the total bonds issued by the company. She is disappointed at the corporate bonds’ performance over the last few years and is planning to make her voice heard during the next round of voting. Do you think she will be able to do this? How? Justify your answer.


What are the three methods to estimate cost of equity?


  • Explain the concept of the time value of money.
  • Imagine you have currently invested £100,000 in a savings account. If the interest rate is expected to be 1% next year, 2% in the year afterward, and 3% in the third year, what will your investment be worth at the end of three years?
  • You have been offered: (i) £70,000 in six years’ time from now; or (ii) £60,000 today. The current interest rate is 3%. Which option will you choose? Briefly justify your answer and show all your workings.
  • When using the Gordon growth formula, assuming that RE > g, describe, in general terms, what happens as g gets closer to RE. Examine, and give examples of, what happens to P0as g becomes very close to RE.
  • If RE = g or RE < g, what are the results of using the Gordon growth formula? Discuss in detail an approach that could be adopted, if you still want to use a dividend discount model.
  • What other situation can cause problems with using the Gordon growth formula? What does this mean for the valuation of companies that are in this situation? Outline any approaches that might assist you in the valuation of these companies.
  • You own shares in Mistral Turbines Plc who have paid dividends since 2013. The annual dividends have been rising annually from £1.05 in 2013 to £1.80 in 2020. The company’s beta was 1.2.

The UK 10 Year Bond rate in 2020 was 0.25% and the market risk premium was assumed to be 4%.

The company has announced that, in order to enable faster business growth, they will be retaining more profit in future years and, therefore, will be reducing the dividend rate by 1% per annum over the next five years starting in 2021. At the end of year 5, they expect to maintain that dividend rate in perpetuity.

  • What is the historical growth rate of Mistral Turbines Plc to 2 decimal points?
  • Derive the current cost of equity for the company to 2 decimal points.
  • Calculate the fundamental value of Mistral Turbines Plc.