Question

Stock in Country Road Industries has a beta of 1.62. The market risk premium is 8.2 percent while T-bills are currently yielding 2.9 percent. Country Road's last paid annual dividend was $1.87 per share and dividends are expected to grow at an annual rate of 3.8 percent indefinitely. The stock sells for $25 a share. What is the estimated cost of equity using the average return of the CAPM and the dividend discount model?

Answer 1

Information provided:

Risk free rate= 2.9%

Beta= 1.62

Market risk premium= 8.2%

Last dividend= $1.87

Dividend growth rate= 3.8%

Current stock price= $25

The cost of equity is calculated using both the capital asset pricing model and the dividend discount model.

The cost of equity capital is calculated using the Capital Asset Pricing Model (CAPM)

The formula is given below:

Ke=Rf+b[E(Rm)-Rf]

where:

Rf=risk-free rate of return which is the yield on default free debt like treasury notes

Rm=expected rate of return on the market.

Rm-Rf= Market risk premium

b= Stock’s beta

Ke= 2.9% + 1.62*8.2%

   = 2.9% + 13.284%

   = 16.1840%

The cost of equity is calculated using the dividend discount model using the below formula:

Ke=D1/Po+g

where:

D1= Next year’s dividend

Po=Current stock price

g=Firm’s growth rate

Ke= $1.87*(1 + 0.038)/ $25 + 0.038

     = 0.0776+ 0.038

     = 0.1156*100

     = 11.56%

The cost of equity is calculated for the question by taking an average of the cost of equity computed using both the capital asset pricing model and the dividend discount model.

Cost of equity= (16.1840% + 11.56%)/2

                      = 13.8720%    13.87%.

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