Cost of Equity Analysis for Diageo

This assignment examines the cost of equity for Diageo, a multinational beverage company. It applies two models – the Capital Asset Pricing Model (CAPM) and the Dividend Growth Model – to determine the expected return for investors. The analysis compares the outcomes of both models and discusses their implications for investment decisions. The report also highlights the limitations of each model and emphasizes the effectiveness of CAPM in providing a more realistic framework for decision-making.

Corporate Finance
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Table of Contents
INTRODUCTION................................................................................................................................3
1. Computation of cost of equity by using dividend growth model ...............................................3
2. Calculating cost of equity of Diageo by using Capital Asset Pricing Model..............................4
3. Critical discussion of different valuation techniques...................................................................4
CONCLUSION ...................................................................................................................................5
References............................................................................................................................................6
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INTRODUCTION
Corporate finance deals with the management of various financial sources which have high
level of influence on the capital structure of the firm. Manager of the firm plays a vital role in
making strategic decisions which enhances the value of firm to the shareholders (Damodaran,
2016). The present report is based on Diageo which is one of the largest British Multinational
alcoholic beverages' company. It is the largest producer of beer and wine whose headquarter is
situated in London. The present report will shed light on the return which Diageo offers to its
shareholders for the appraising risk which they have undertaken by investing money in the equity
shares.
1. Computation of cost of equity by using dividend growth model
Cost of equity refers to the return which business organization pays to their equity
shareholders in form of divided. It assists investors in making suitable decisions in relation to
investing money. Moreover, capitalist invest money with the aim to make value addition on it
through equity share returns (Cornell, 2015). In this, by assessing the growth which takes place in
the dividend of Diageo investors are become able to make further profitable decision. Dividend is
one of the main factors which offers high level of benefit to the shareholders (Barberis and et.al.,
2015). In this, existing and potential shareholders can make suitable investment decision by taking
into account the dividend growth model.
Dividend growth model: P = D / K – G
P: Price of the security
K: Required rate or return according to the CAPM model
g: Expected growth rate
D = Dividend payout ratio
K = .73%
D = 67.9%
G = 3.58%
P: .679 / .0073 - .0358
= .679 / -.0285
= -23.82
From the above calculation it has been analyzed that dividend payout ratio of Diageo is
67.9% in the accounting year 2015. Besides this, growth which takes place in the share prices of the
firm during the period of two years are 3.58%. Further, through CAPM model it has been assessed
that investors needed .73% return for the risk taken by them. In this. On the basis of the above
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aspect it can be stated that negative growth takes place in the dividend aspect which is offered by
Diageo. During the period of 2 years high level of fluctuation took place in the share prices of the
firm. Thus, investors do not invest in the shares of Diageo due to the very less return or profit
margin offered by it. Thus, if investors invest money in the shares of Diageo then they the
maximum limit of loss will be 23.82.
2. Calculating cost of equity of Diageo by using Capital Asset Pricing Model
CAPM model provides deeper insight about the relationship which exist between the risk
and expected return. This is used for allocating price to the securities which are highly risky in
nature. This model undertakes two factors such as time value of money and risk aspect. In this
regard, time value of money is employed by the financial analyst in the risk free rate (Maio and
Santa-Clara, 2015). Along with the risk free return the other part of the calculation presents the
amount of compensation which investors require for the risk which is taken by them additionally.
Moreover, when investors take additional risk then they want to get higher return as compared to
the average limit. This model assists financial analyst in creating suitable portfolio.
CAPM model
Particulars Figures
Beta 0.06
Risk free return (RFR) 0.51%
Risk market premium (Rm) -3.45%
Required rate of return (Ke) 0.73%
The above table presents that investor will get minimum return of .51% if they invest their
money in the securities of Diageo. Investors who are risk averse consider this aspect while taking
decision about the investment. Besides this, beta presents the extent ton which particular type of
security is highly risky (Fard and Falah, 2015). Presented framework shows that securities of
Diageo are risky to the extent of .006. Thus, from the comparison of risk free rate and premium it
has been identified that the required rate of return is very low. On 1st April 2014 the closing price of
the share was 1816.5, whereas it reached on 1881.5 on 31 March 2016. Thus, there is no significant
increase takes place in the share prices of firm during the period of two years. Hence, investors do
not employ huge amount of money in the shares of Diageo.
3. Critical discussion of different valuation techniques
From the above assessment it has been determined that values which are provided by CAPM
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model are highly realistic as compared to dividend growth model. Moreover, this model assumes
that dividend per share grows with a constant rate. Whereas, in practical life it is not possible.
Market situation, growth and profitability etc. are the factors which have high level of influence on
the dividend policy of the firm. Along with this, divided model offers solution on the basis of
company's data and fundamentals (Piamsuwannakit and Sriboonchitta, 2015). This aspect also
limits the significance of such method. Moreover, there is the possibility that data of the company
is not highly accurate or appropriate. In contrast to this, CAPM model presents highly suitable and
realistic framework for the purpose of decision making (Johnston, 2016). This model undertakes all
the external factors which are highly related to the market such as beta, risk free rate etc. Hence, by
considering all such aspects investors able to make most appropriate decision which makes value
addition in their money.
CONCLUSION
From this report, it has been concluded that cost of equity is the most effectual factor which
provides assistance to the investors in making suitable decision. It can be stated that Diageo offers
very less return to the investors in against to risk prevailed in the securities. Besides this, it can be
inferred that outcomes of CAPM model and dividend growth model are same to some extent.
However, CAPM is more effectual model which assists investors in making suitable decision in
relation to their investment and portfolio creation.
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REFERENCES
Books and Journals
Barberis, N. and et.al., 2015. X-CAPM: An extrapolative capital asset pricing model. Journal of
Financial Economics. 115(1). pp.1-24.
Cornell, B., 2015. Using Dividend Discount Models to Estimate Expected Returns. The Journal of
Investing. 24(1). pp.48-51.
Damodaran, A., 2016. Damodaran on valuation: security analysis for investment and corporate
finance (Vol. 324). John Wiley & Sons.
Fard, H.V. and Falah, A.B., 2015. A New Modified CAPM Model: The Two Beta CAPM. Jurnal
UMP Social Sciences and Technology Management. 3(1).
Maio, P. and Santa-Clara, P., 2015. Dividend yields, dividend growth, and return predictability in
the cross section of stocks. Journal of Financial and Quantitative Analysis. 50(1-2). pp.33-
60.
Piamsuwannakit, S. and Sriboonchitta, S., 2015. Forecasting risk and returns: CAPM model with
belief functions. In Econometrics of Risk (pp. 259-271). Springer International Publishing.
Online
Johnston, K., 2016. Difference Between Capital Asset Pricing & the Dividend Growth Model.
Online. Available through: <http://smallbusiness.chron.com/difference-between-capital-
asset-pricing-dividend-growth-model-35940.html>. [Accessed on 4th July 2016].
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