Question

Rossdale Co. stock currently sells for $68.91 per share and has a beta of .88. The market risk premium is 7.10 percent and the risk-free rate is 2.91 percent annually. The company just paid a dividend of $3.57 per share, which it has pledged to increase at an annual rate of 3.25 percent indefinitely. What is your best estimate of the company's cost of equity?

Multiple Choice

• 9.56%

• 8.08%

• 8.88%

• 7.74%

Answer 1

The best estimate of the company's cost of equity

The best estimate of the company's cost of equity is the average of the cost of equity calculated under CAPM Approach and the Dividend Discount Model

Cost of Equity under CAPM Approach

As per Capital Asset Pricing Model [CAPM], The Cost of Equity Capital is computed by using the following equation

Cost of Equity Capital = Risk-free Rate + [Beta x Market Risk Premium]

= 2.91% + [0.88 x 7.10%]

= 2.91% + 6.25%

= 9.16%

Cost of Equity under Dividend Discount Model

Cost of Equity under Dividend Discount Model = [Dividend per share in next year / Current market price per share] + Dividend growth rate per year

= [($3.57 x 1.0325) / $68.91] + 0.0325

= [$3.6860 / $68.91] + 0.0325

= 0.0535 + 0.0325

= 0.0860 or

= 8.60%

Therefore, the best estimate of the company's cost of equity is the average of the cost of equity calculated under CAPM Approach and the Dividend Discount Model

Cost of Equity = [Cost of Equity under CAPM Approach + Cost of Equity under Dividend Discount Model] / 2

= [9.16% + 8.60%] / 2

= 17.76% / 2

= 8.88%

“Hence, the best estimate of the company's cost of equity will be 8.88%”