Question

Stock in Country Road Industries has a beta of 1.04. The market risk premium is 8.5 percent, and T-bills are currently yielding 4 percent. The company's most recent dividend was $1.8 per share, and dividends are expected to grow at a 5.5 percent annual rate indefinitely. If the stock sells for $39 per share, what is your best estimate of the company's cost of equity? (Do not round your intermediate calculations.)

Answer 1

As per CAPM model, we can calculate expected return using the formuale

Re =Rf + beta ( Rm-Rf)

were Re = Expected rate of return

Rf = Risk free rate =4% in this question

Beta = 1.04

Rm- Rf = 8.5

Substituting values in the equation we get

Re =Rf + beta ( Rm-Rf)

Re = 4 +1.04 (8.5)

Re = 4+ 8.84

Re = 12.84 as per CAPM Model

As per CAPM model Country road industries cost of capital = 12.84

As per Gordans formula Intrinsic Value of a share is given as

IV = D₀ (1+g) /(Re-g)

were D0 = recent dividend =1.8

g = growth rate = 5.5%

Re = Cost of equity we have to calculate

IV =39

Substituting valuesin the equation we get

IV = D₀ (1+g) /(Re-g)

39 = 1.8(1.055)/(Re-0.055)

39 =1.899/(Re -0.055)

39Re -2.145= 1.899

39Re =1.899+2.145

39Re =4.044

Re =4.044/39

Re =0.103692

Re =10.3692

so, as per Gordans formula cost of equity =10.3692

The best estimate of cost of equity = Average of cost of equity derived from above formulaes

The best estimate of cost of equity =(12.84+10.3692)/2

The best estimate of cost of equity =11.6046

The best estimate of cost of equity =11.60