I am having trouble to understand the answer from Mock 2 Section 4 on Share price / WACC. Maybe you could summarise it in a much simpler way.
In the paragraph, it says that “a decrease in the share price means that the cost of equity has increased”. Can you please explain this further as for me the equity balance on the Balance Sheet should never change.
Cost of equity is the required rate of return by the shareholders by providing equity capital to the company and not just the balance in the Balance Sheet.
To show the visual effect, let’s look at the formula for cost of equity. Cost of equity (Ke) can be calculated using the DVM method, like so:
Ke = [d0 (1+g)/MV] + g
Where d0 is current dividends, g is dividend growth rate, MV is market value of equity.
So if share price (meaning market value price) decreases, cost of equity increases.
To prove it in practical calculations, let’s use MV at 100 and then assume it decreases to 50. Let’s also assume dividends at 5 and growth rate is 10%.
MV at 100: Ke = [5 (1 + 0.1) / 100] + 0.1 = [5.5/100] + 0.1 = 0.055 + 0.1 = 0.155
MV at 50: Ke = [5 (1 + 0.1) / 50] + 0.1 = [5.5/50] + 0.1 = 0.11 + 0.1 = 0.21
Hope this helps.
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