Question

Floyd Industries stock has a beta of 1.20. The company just paid a dividend of $.50, and the dividends are expected to grow at 6 percent per year. The expected return on the market is 11 percent, and Treasury bills are yielding 5.9 percent. The most recent stock price for the company is $76.
a.Calculate the cost of equity using the DDM method. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

DDM method %
b.Calculate the cost of equity using the SML method. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

Answer:

a. 6.7%

b. 12.0%

Explanation:

a. DDM

Dividende Discount Method is used to calculate the price of the stock using Dividend, rate of return and growth rate.

Return on equity = [ Dividend x ( 1 + growth rate ) / Price of stock ] + Growth Rate

Return on equity = [ $0.5 x ( 1 + 6% ) / $76 ] + 6%

Return on equity = [ $0.5 x ( 1.06 ) / $76 ] + 0.06

Return on equity = 6.7%

b. SML

Security Market line method uses calculates the cost of capital using following formula

Re  =  R f  +  β   (  Rm  −  R f  )

Rf = Risk free rate

β = stock beta

Rm = Market rate

Re =Expected rate

Re = 5.9% + 1.20 ( 11% - 5.9% )

Re = 12.02%