Cost of Capital and Valuation
To find the shareholder value if maximized or not is to find the value stock price using relevant information and compare the same with quoted price from stock market to see any evidence of overvaluation of undervaluation. The intrinsic value of the company is the true value of stock using historical information of some estimates as basis.
To do the same, there is a need to find first the company’s cost of capital or WACC and apply the same together with the CAPM model (Van Horne,1992) which gives the formula as: Ks = RF + ((MR-RF) x B); where Ks represents the required rate of return; RF, the risk free rate represented by treasury bill rate of Bank of England base rate; MR, as the average market rate of the same stock in the market; and B, as the beta or a measure of variability which is normally given. Using RF of 5. 25% (Housepricecrash, 2008) from the Bank of England and a beta of 1.
5 (Telegraph. co. uk, 2008). as well as market rate of 5. 98 (See Appendix 1), the company’ cost of capita or required rate of return would be computed at 6. 345% or Ks = RF + ((MR-RF) x B) = 5. 25% + 1. 5 (5. 98%- 5. 25%) = 6. 345%. Note that the market rate of 5. 98% 10. 85% was extracted by estimating the same by getting the reciprocal of the average P/E ratios of selected firms in the retail industry (Appendix 1). As to how the companies used are selected depends on the availability of information.
The computed Ks is the same as the opportunity cost of doing business which Marks and Spencer must earned if it wants to stay in business. After getting the Ks, valuation under the constant growth model or Gordon Model is now possible. It must simple to do the same since it just involves plugging the rates and the figures using the formula P0= D1/ (KS-g). The computed intrinsic value is 383. 37p per share. This figure could be compared at the quoted price from the London Stock Exchange at 373. 5 pence per share (Telegraph, 2008).
It must noted that plugging in the discount rate of 10. 85% as KS in the formula: P0= D1/(KS-g) , formula will produce a positive value that would represent the stock price because the divisor would be a negative number and stock price cannot be negative figure. An assumption was therefore made to have a growth rate of 1. 5% in dividend per share instead of 15% as computed based on four year average. See Appendix 2 The application of the model revealed that the constant growth is working only if rate of dividend increase is below cost of capital.
Assumption of the said rate is a requirement for the model to work. The assumption has however basis in theory as the company should be giving dividends less than its earnings. What may have happened to Marks and Spencer was to impress upon stockholders that the company was earning big which as actually true for 2005, 2006 and 2007 and that the company gave hefty dividends for those years. However, it the average of the actual figures are used for the said period, they produce an inapplicability of the constant growth model.