Stock in Dragula Industries has a beta of 1.1. The market risk premium is 7 percent, and T-bills are currently yielding 5.00 percent. The company’s most recent dividend was $1.40 per share, and dividends are expected to grow at a 7.0 percent annual rate indefinitely. If the stock sells for $35 per share, what is your best estimate of the company’s cost of equity? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

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andromache andromache · Answer 1 · 2019-12-23T10:21:49+01:00

Answer:

11.99%

Explanation:

For computing the estimation of cost of equity, first we have to determine the cost of equity based on CAPM which is shown below:

In this question, we apply the Capital Asset Pricing Model (CAPM) formula which is shown below

Expected rate of return = Risk-free rate of return + Beta × (Market rate of return - Risk-free rate of return)

= 5% + 1.1 × 7%

= 5% + 7.7%

= 12.7%

The (Market rate of return - Risk-free rate of return) is also known as market risk premium and the same is shown in the computation part.

Now the cost of equity based on growth rate which is shown below:

= Current year dividend ÷ price + Growth rate

where,

The current dividend would be

= $1.40 + $1.40× 7%

= $1.40 + $0.098

= $1.498

The other things would remain the same

So, the cost of common equity would be

= $1.498 ÷ $35 + 7%

= 0.0428 + 0.07

= 11.28%

Now the best estimation would be

= (12.7% + 11.28%) ÷ 2

= 11.99%