Question

UWY's expected dividend next year is $2.50 per share. They have maintained a constant payout ratio of 50% during the past 7 years. Seven years ago its EPS was $1.50. The firm's beta coefficient is 1.2. The estimated market risk premium is 6%, and the risk-free rate is 4%. Roland's A-rated bonds are yielding 9%, and its current stock price is $30. What is the estimated cost of UWY’s retained earnings, r_s?

Thanks!

Answer 1

Let us first find growth rate of dividend

7 years ago , EPS was $1.50 and payout ratio = 50% and hence dividend per share = 1.50 x 50% = 0.75

Here g can be found using formula of FV

FV = PV(1+g)^n

.2.5 = 0.75(1+g)^7

=3.3333 = (1+g)^7

3.33331/7 = 1+g

3.33330.14285 = 1+g

1.1876 = 1+g

g = 0.1876

i.e 18.76%

Now as per dividend discount model cost of retain earnings = dividend of next year / Price per share + growth rate

= 2.50 / 30 + 18.76%

=0.08333 + 0.1876

=0.2710

i.e 27.10 %

Now lets calculate cost of retain earning using CAPM method

Cost of retain earnings = Risk free rate of return + beta(Market risk premium)

= 4% + 1.2(6%)

=4% + 7.2%

=11.2%

Looking at the growth it can be said that the company is experiencing supernormal growth and it is not resonable that this growth will continue and hence cost of retain earning is 11.2% which is resonable