Question

Suppose stock of Company ABC has a beta of 1.2. The risk premium is 8%, and the risk-free rate is 6%. ABC’s last dividend was $2 per share, and the dividend is expected to grow at 8% indefinitely. The stock sells for $30. What is ABC’s cost of equity capital?

Answer #1

Using CAPM equation; | |||||

Rs=Rf+Beta*(Rm-Rf) | |||||

Rs=Expected return of stock | |||||

Rf=Risk free rate=6% | |||||

Rm =Market expected return | |||||

(Rm-Rf)=Risk Premium=8% | |||||

Beta=1.2 | |||||

Rs=6+1.2*8= | 15.60% | ||||

D0 | Last dividend paid | $2 | |||

g | Dividend growth Rate | 0.08 | |||

D1=D0*(1+g) | Next year dividend | $2.16 | |||

Required Return onEquity=R | |||||

P0=D1/(R-g) | P0=Market Price=$30 | ||||

30=2.16/(R-0.08) | |||||

R=(2.16/30)+0.08= | 15.20% | 0.072 | |||

CAPM:CapitalAsset Pricing Model | |||||

DDM:Dividend Discount Model | |||||

As Per CAPM | 15.60% | ||||

As per DDM | 15.20% | ||||

We can take the average: | |||||

Cost of Equity | 15.4% | ||||

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