Question

Stock in ABC Enterprises has a beta of 1.28. The market risk premium is 7.4 percent, and T-bills are currently yielding 3.6 percent. ABC's most recently paid dividend was $1.62 per share, and dividends are expected to grow at an annual rate of 2 percent indefinitely. If the stock sells for $38 a share, what is your best estimate of ABC's cost of equity?

Answer 1

Answer:

Cost of equity = 6.34%

Explanation:

Provided information is as follows:

Beta = 1.28

Market risk premium = 7.4%

T-Bills yield = Risk free return = 3.6%

Dividend given = $1.62

Growth rate g = 2%

Current price = $38

Using Capital Asset Pricing Model

Cost of equity = Risk free return + Beta (Market risk - Risk free return)

= 3.6% + 1.28 (7.4 - 3.6)

= 3.6% + 4.864% = 8.464%

Using dividend growth model

Current price of share = $\frac{Dividend\: paid \: + \: growth }{Cost \: of \: equity\: - \: growth}$

$38 = $\frac{1.62 + (0.02\times1.62)}{Cost\: of\: equity\: -\: 0.02}$

Cost of equity - 0.02 = $\frac{1.6524}{38}$ = 4.34%

Cost of equity = 4.34 + 2 = 6.34%

But the best estimate is using dividend growth model as this is company specific while capital asset pricing model uses the industry and market rates and do not consider company performance.

Therefore, cost of equity = 6.34%