In: Finance
TeachMeFinance has a beta of 0.92. The Treasury bill rate is 5 percent. The market risk premium is 10 percent. The company paid a $1.8 per share dividend a couple of days ago, and it is planning to increase its dividends at a 7 percent annual rate indefinitely. You also know that the company's shares of stock can now be purchased for $34 per share. Based on the above information, what is your best estimate of TeachMeFinance's cost of equity? (Do not round your intermediate calculations.) |
rev: 09_20_2012
12.66%
14.2%
11.33%
13.43%
9.6%
Solution :
Calculation of Cost of equity as per CAPM:
As per the Capital Asset Pricing model (CAPM), Cost of equity is calculated using the following formula:
Cost of equity = (RE) = RF + ?* ( RM – RF )
Where RF = Risk free rate
? = Beta of the stock
RM = Expected market return / Return on market
As per the data given in the question
RF = Risk free rate = Treasury bill rate = 0.05 ; ? = 0.92 ;
Market risk premium = (Risk free rate – Return on market) = (RM - RF )= 0.10
Applying the same in the formula above we have
Cost of equity = (RE) = 0.05 + 0.92 * (0.10)
= 0.05 + 0.0092 = 0.142 = 14.2 %
Thus the Cost of equity of the company as per CAPM = 0.142 = 14.2 %.
Calculation of Cost of equity as per Dividend Growth model:
As per the Dividend growth model value of a stock/share = D0 * (1+g) / (Ke – g)
Where D0 = Dividend paid in year 0 or last dividend paid
g = Growth rate
Ke = Cost of Equity
As per the Information given in the question:
D0 = $ 1.8 ; g= 7% ; Value of stock = $ 34 per share
Applying the above values in the formula for value of a stock as per the Dividend Growth model we have:
34 = 1.8 ( 1 + 0.07 ) / (Ke – 0.07)
34 = 1.8 ( 1.07 ) / (Ke – 0.07)
34 = 1.926 / (Ke – 0.07)
34 (Ke – 0.07) = $1.926
(Ke – 0.07) = 1.926/34 = 0.0566
(Ke – 0.07) = 0.0566
Ke = 0.07 + 0.0566 = 0.1266
This Cost of Equity as per Dividend growth model = 12.66 %.
The following are the best estimates of cost of equity of Teach Me Finance:
1. As per CAPM : 14.2 %
2. As per Dividend growth model : 12.66 %