Question

National Home Rentals has a beta of 1.24, a stock price of $22, and recently paid an annual dividend of $0.94 a share. The dividend growth rate is 3 percent. The risk-free rate is 3.1 percent and the expected market return is 10.6 percent. What is the firm's cost of equity?

Answer 1

As per CAPM(Capital asset Pricing Model) cost of equity = Risk free rate + Premium expected of risk

Cost of equity = Rf + (Rm - Rf)

Rf = Risk free rate

= Beta of security

Rm = Market Rate of Return

Given:

Rf = Risk free rate = 3.1%

= Beta of security = 1.24

Rm = Market Rate of Return = 10.6%

Solution:

Cost of equity = Rf + (Rm - Rf)

Cost of equity = 3.1 + 1.24 (10.6 - 3.1)

Cost of equity = 3.1 + 1.24 (6.9)

Cost of equity = 3.1 + 8.556

Cost of equity = 11.656%

As per Gordon's Growth Model

Price of share = Dividend of the following year/ (Cost of equity - growth rate)

Given:

Price of share = 22

Dividend of the following year = Dividend paid * (1+ growth rate) = 0.94 * (1+.03) = 0.9682

Cost of equity = To find?

Growt Rate = 3%

Solution:

Price of share = Dividend of the following year/ (Cost of equity - growth rate)

22 = .9682 / (Cost of equity - .03)

(Cost of equity - .03) =  0.9682 /22

(Cost of equity - .03) =  0.0440

Cost of equity = 0.0440 +.03

Cost of equity = 0.074 = 7.4%

As per CAPM approach cost of equity = 11.656% whereas as per Gordon growth model cost of equity is 7.4%