Question

Identify the components of the methods employed to determine the cost of (1) preferred stock (2) Common stock, & new equity

Answer 1

The most commonly accepted method for calculating cost of equity ( preferred stock as well ) comes from the Nobel Prize-winning capital asset pricing model (CAPM): The cost of equity is expressed formulaically below ( also called as components of CAPM method ) :

Re = r_f + (r_m – r_f) * ?

Where:

• Re = the required rate of return on equity
• r_f = the risk free rate
• r_m – r_f = the market risk premium
• ? = beta coefficient = unsystematic risk

Another method to determine cost of Preferred stock, Common stock & New equity is Dividend capitalization method. The components of this method can be found out in the following formula :

ke = D₁ / P₀  + g

Where, k_e = cost of preferred stock or Common stock or New Equity

D₁ = Divedend per share next year

P₀  = Current Market Value of stock

g = Growth rate of dividend