The managing director of Wemere, a medium-sized private company, wishes to improve the company’s investment decision-making process by using discounted cash flow techniques. He is disappointed to learn that estimates of a company’s cost of equity usually require information on share prices which, for a private company, are not available. His deputy suggests that the cost of equity can be estimated by using data for Folten plc, a similarsized company in the same industry whose shares are listed on the AIM, and he has produced two suggested discount rates for use in Wemere’s future investment appraisal. Both of these estimates are in excess of 17 per cent p.a., which the managing director believes to be very high, especially as the company has just agreed a fixed rate bank loan at 13 per cent p.a. to finance a small expansion of existing operations. He has checked the calculations, which are numerically correct, but wonders if there are any errors of principle.
Estimate 1: Capital Asset Pricing Model Data have been purchased from a leading business school Equity Beta of Folten: 1.4 Market return: 18%
Treasury Bill yield: 12%
The cost of capital is 18, + (18, - 12,)1.4 = 26.4,. This rate must be adjusted to include inflation at the current level of 6 per cent. The recommended discount rate is 32.4 per cent.
Estimate 2: Dividend Growth Model Folten plc Year Average share price (pence)
Dividend per share (pence)
2010 2011 2012 2013 2014 193 109 96 116 130 9.23 10.06 10.97 11.95 13.03 The cost of capital is: D1>(P -g), where D1 is the expected dividend, P is the market price and g is the growth rate of dividends (= 14.20p>(138p - 9) = 11.01,)
When inflation is included, the discount rate is 17.01 per cent.
Other financial information on the two companies is presented here:
Wemere £000 Folten £000 Fixed assets 7,200 7,600 Current assets 7,600 7,800 Less: Current liabilities (3,900) (3,700)
10,900 11,700 Financed by:
Ordinary shares (25 pence) 2,000 1,800 Reserves 6,500 5,500 Term loans 2,400 4,400 10,900 11,700 Notes 1 The current ex div share price of Folten plc is 138 pence.
2 Wemere’s board of directors has recently rejected a takeover bid of £10.6 million.
3 Corporate tax is paid at the rate of 35 per cent.
Required

(a) Explain any errors of principle that have been made in the two estimates of the cost of capital and produce revised estimates using both of the methods.
State clearly any assumptions that you make.

(b) Discuss which of your revised estimates Wemere should use as the discount rate for capital investment appraisal.