Question

Stock in Country Road Industries has a beta of 0.85. 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 4.5 percent annual rate indefinitely. If the stock sells for $33 per share, what is your best estimate of the company's cost of equity? (Do not round your intermediate calculations.) 9.21% 10.2% 11.23% 7.83% 10.71%

Answer 1

Ans:- 10.71%

Calculations:-

a) AS per CAPM model,

Required return = Rf+Beta*(Rm-Rf)

Where ,

Rf= risk free rate = 4%

Beta= 0.85

Rm-Rf= Market risk premium = 8.5%

Substituting the values ,

Required return =4%+0.85*8.5%= 11.225%

Hence as per CAPM model cost of equity = 11.225%

b) As per dividend growth model

Price of share =[ DPSo*(1+g)]/(ke-g)

Where

Price of share = $33

DPS0= $1.80

Ke= Cost of equity

g= growth rate = 4.5%

Substituting the values,

33=1.80*1.045/(ke-0.045)

Ke-0.045=1.881/33

ke=0.057+0.045

ke=0.102 i.e. 10.20%

The cost of capital as per dividend growth model = 10.20%

c) The best estimate would be the average of both =(11.225%+10.20%)/2

                                                                                               =10.71%

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