Question

Haliford Corporation expects to have earnings this coming year of $3.311 per share. Halliford plans to retail all of its earnings for the next two years. Then, for the subsequent two years, the firm will retain 53% of its earnings. It will retain 18% of its earnings from that point onward. Each year, retained earnings will be invested in new projects with an expected return of 27.8% per year. Any earnings that are not retained will be paid out as dividends. Assume Halliford's share count remains constant and all earnings growth comes from the investment of retained earnings. If Halliford's equity cost of capital is 10.3%, what price would you estimate for Halliford stock?

The stock price will be $___. (Round to the nearest cent.)

Answer 1

What Is the Cost of Equity?

The cost of equity is the return a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the required rate of return. A firm's cost of equity represents the compensation the market demands in exchange for owning the asset and bearing the risk of ownership. The traditional formula for the cost of equity is the dividend capitalization model and the capital asset pricing model (CAPM).

The cost of equity can be calculated by using the CAPM (Capital Asset Pricing Model) or Dividend Capitalization Model (for companies that pay out dividends).

CAPM (Capital Asset Pricing Model)

CAPM takes into account the riskiness of an investment relative to the market. The model is less exact due to the estimates made in the calculation (because it uses historical information).

CAPM Formula:

E(R_i) = R_f + β_i * [E(R_m) – R_f]

Where:

E(R_i) = Expected return on asset i

R_f = Risk-free rate of return

β_i = Beta of asset i

E(R_m) = Expected market return

In this problem since dividends are not paid out regularly you cannot use the dividend capitalisation model to obtain the answer. Hence one should opt for CAPM method. But I am not very well versed in that area and hence am not able to answer that. Hope this helps in some way