(C) Discounted Cash Flow Approach

The DCF approach is also called the dividend-yield-plus-growth rate approach, and calculated as


Investors expected to receive a dividend yield (D1/Po) plus a capital gain (g) for a total expected return of Kes. At equilibrium, this expected return would be equal to the required return (Ks).

Ks = Kes

  • The firm must earn more than the cost of common stock (Ke) due to flotation cost.
  • When a firm earns more than Ke, the price of the stock will rise.
  • When a firm earns exactly Ke, EPS will not fall, expected dividend can be maintained, and consequently the price per share will not decline.
  • When a firm earns less than Ke, then earnings, dividends, and growth will fall below expectations, causing the price of the stock to decline.

(v) Weighted-Average and Marginal Cost of Capital Concepts

An optimal (target) capital structure is a mix of debt, preferred stock, and common stock that maximizes a firm’s stock price. The goal of the finance manager should be then to raise new capital in a manner that will keep the actual capital structure on target over time. The firm’s WACC is calculated based on the target proportions of capital and the cost of the capital components, all based on after-tax costs. The WACC could be used as a hurdle rate for capital investment projects and is computed as:

The weights could be based on ...

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