- CFA Exams
- CFA Level I Exam
- Study Session 11. Equity Valuation (3)
- Reading 30. Residual Income Valuation
- Subject 1. Calculating residual income

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**CFA Practice Question**

Joiner Industries has just paid a dividend of 1.65 a share and the market expects its dividend to continue to grow at a constant rate of 5.5% for the foreseeable future. The company wants to issue new shares to raise funds for an investment project. Based on its risk, investors require a 14% rate of return. Investment banking fees will amount to 4% of the sales proceeds. Joiner's cost of new equity is

A. 14.35%

B. 18%

C. 15.5%

**Explanation:**Under a constant growth model, k

_{equity}= Dividend yield + Capital gains yield

14 = Dividend yield + 5.5 => Dividend yield = 14 - 5.5 = 8.5%

k

_{new equity}= [Dividend yield / (1 - Flotation cost)] + Capital gains yield = [8.5 / (1 - 0.04)] + 5.5 = 14.35%

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**User Contributed Comments**
11

User |
Comment |
---|---|

danlan2 |
(k%-5.5%)*(1-0.04)=14%-5.5% so k=14.35% |

HenryQ |
Is 5.5% capital gain yield or dividend yield? |

jhmorris |
This problem can also be solved using the Gordon Growth model. 1. Find the value of the equity 1.65(1.055) / (0.14 - 0.055) = 20.47941176 2. Since issuance costs are 4% of value, reduce the value of the equity by that percentage. 20.47941176(0.96) = 19.66023529 3. Take the fee-adjusted value and plug it into the Gordon Growth model and solve for r. 19.66023529 = 1.74075 / (r - 0.055) r = 0.143541667 |

pjdeschenes |
nice. |

DZ2008 |
brilliant jhmorris, brilliant |

Allen88 |
very nice jhmorris |

omf24 |
Impressive jhmorris. |

tim2 |
The calculation seems silly to me. Why is the answer not 14/(1-.04)? It says in the question investment banking fees will be 4% of the sales proceeds, not 4% of the proportion of the sales proceeds atributable to the value of the company arising form dividend yield rather than capital growth. Where on earth did they get that from? |

charomano |
Ke = Dividend Yield + Capital gains yield = D/P + g Gordon growth model => P = D/(k-g) => k = D/P + g |

swt326 |
Thanks jhmorris, it's much better to derive an answer through an already known formula than memorizing another. |

Allstats |
Nice question. Well done jhmorris |