Question

3. You have been asked to analyze the stock of Watson Corp, and need to calculate its cost of equity in order to do so. Your boss has instructed you to calculate the cost of equity in two different ways – the dividend growth model approach and the CAPM approach – and then average the two figures to determine your final answer. The stock currently trades at $45, and next year’s dividend (D₁) is estimated to be $1.18. The previous three years of dividends were $1.02 (D_-2), $1.25 (D_-1), and $1.10 (D₀); use the geometric mean of the four dividends to estimate the dividend growth rate. The risk free rate is currently 3%, the expected market return is 10%, and Watson’s beta is 0.6. What are your three cost of equity estimates (dividend growth, CAPM, & average of the two)?

Answer 1