Question

In: Finance

TeachMeFinance has a beta of 0.92. The Treasury bill rate is 5 percent. The market risk...

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%

Solutions

Expert Solution

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 %


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