Question

Bunkhouse Electronics is a recently incorporated firm that makes electronic entertainment systems. Its earnings and dividends have been growing at a rate of 36.5%, and the current dividend yield is 8.50%. Its beta is 1.33, the market risk premium is 14.50%, and the risk-free rate is 2.70%.

a. Use the CAPM to estimate the firm’s cost of equity

Now use the constant growth model to estimate the cost of equity. (Do not round intermediate calculations. Enter your answer as a whole percent.)

Answer 1

1) According to CAPM cost of equity = Risk Free Rate of Return + (Market Risk Premium x Beta of the Stock)

Given the Beta of Stock = 1.33

Risk Free Rate of Return = 2.70 %

Market Risk Premium = 14.50 %

Now, Cost of Equity = 2.70 + (14.50 x 1.33) = 21.98%

Now, Cosntant Growth Model is based on the assumption that the required rate of retrun should be greater than the Cosntant Growth Rate.Therefore the Cost of Equity computed Using CAPM cannot be used to calculate the price of share using Constant Growth DDM model. If used the price of share would be negative.

According to Constant Growth Dividend Discount Model Cost of Equity = Dividend Yield + Growth Rate of Dividend

Given, the Dividend Yield = 8.5%

and the Growth Rate of Dividend = 36.5%

Therefore Cost of Equity using Constant Growth Model = 36.5% + 8.5% = 45%