Recent financial information relating to Close Co, a stock market listed company, is as follows.
Financial analysts have forecast that the dividends of Close Co will grow in the future at a rate of 4% per year. This is slightly less than the forecast growth rate of the profit after tax (earnings) of the company, which is 5% per year. The finance director of Close Co thinks that, considering the risk associated with expected earnings growth, an earnings yield of 11% per year can be used for valuation purposes.
Close Co has a cost of equity of 10% per year and a before-tax cost of debt of 7% per year. The 8% bonds will be redeemed at nominal value in six years’ time. Close Co pays tax at an annual rate of 30% per year and the ex-dividend share price of the company is $8·50 per share.
Required:
(a) Calculate the value of Close Co using the following methods:
(i) net asset value method;
(ii) dividend growth model;
(iii) earnings yield method. (5 marks)
(b) Discuss the weaknesses of the dividend growth model as a way of valuing a company and its shares. (5 marks)
(c) Calculate the weighted average after-tax cost of capital of Close Co using market values where appropriate. (8 marks)
(d) Discuss the circumstances under which the weighted average cost of capital (WACC) can be used as a discount rate in investment appraisal. Briefly indicate alternative approaches that could be adopted when using the WACC is not appropriate. (7 marks)