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.
Required:
a. Calculate the cost of equity using the DDM method.
b. Calculate the cost of equity using the SML method.

Answer 1

Answer:

a.

r = 0.06697 or 6.697% rounded off to 6.70%

b.

r = 0.1202 or 12.02%

Explanation:

a.

Using the constant growth model of dividend discount model, we can calculate the price of the stock today. The DDM values a stock based on the present value of the expected future dividends from the stock. The formula for price today under this model is,

P0 = D0 * (1+g) / (r - g)

Where,

• D0 * (1+g) is dividend expected for the next period /year

• g is the growth rate

• r is the required rate of return or cost of equity

Plugging in the values for P0, D0 and g in the formula, we can calculate the value of r to be,

76 = 0.5 * (1+0.06) / (r - 0.06)

76 * (r - 0.06) = 0.53

76r - 4.56 = 0.53

76r = 0.53 + 4.56

r = 5.09 / 76

r = 0.06697 or 6.697% rounded off to 6.70%

.

Using the CAPM, we can calculate the required/expected rate of return on a stock. This is the minimum return required by the investors to invest in a stock based on its systematic risk, the market's risk premium and the risk free rate.  

The formula for required rate of return under CAPM is,

r = rRF + Beta * (rM - rRF)

Where,

rRF is the risk free rate

rM is the market return

r = 0.059 + 1.2 * (0.11 - 0.059)

r = 0.1202 or 12.02%