Question

Kmart shares have a beta of 1.05. The company has just paid a dividend of $1.10, and the dividends are expected to grow at 2.5%. The expected return of the market is 9% and the risk-free rate is 1.5%. The most recent share price for Kmart’s shares is $51. a. Calculate the cost of equity using the dividend growth model method. b. Calculate the cost of equity using the SML method. c. Why do you think your estimates in a and b are so different?

Answer 1

a). Calculating Cost of equity using the Dividend Growth Model (DGM)method formula:-

Dividend just Paid (D0) = $1.10

Growth Rate of Dividend(g) = 2.5% per year

Current Share Price (P0) = $51

Ke = 4.71%

So, Cost of Equity is 4.71%

b). Calculating Cost of equity using the SML method formula:-

​​​​​​

Rf = Risk free Return = 1.5%  
Rm = Market return = 9%

Beta of STock = 1.05

Required Rate of Return = 1.5% + 1.05(9% -1.5%)

= 9.375%

So, Cost of equity is 9.375%

c). DGM method calculates Investors return(or cost of Equity) based on future dividends while in SML method investor return is calculated based on Systematic risk or various other factors of market like Risk free return or Market return.

Thus, Both methods uses different approaches. Hence, are estimates in a and b are different.