Question

Runtan Inc. has just paid an annual dividend of $0.45 per share. Analysts expect the firm's dividends to grow by 5% forever. Its stock price is $34.9 and its beta is 1.7. The risk-free rate is 2% and the expected return on the market portfolio is 8%.

What is the best guess for the cost of equity?

Answer 1

The cost of equity as per CAPM is computed as shown below:

= risk free rate + beta x (return on market - risk free rate)

= 2% + 1.7 x (0.08 - 0.02)

= 12.2%

Cost of equity as per dividend growth model will be as follows:

= [ Current dividend x (1 + growth rate) / current price ] + growth rate

= [ [ $ 0.45 x 1.05 ] / $ 34.9 ] + 5%

= 6.353868195%

So, we shall take the average of above computed rates as shown:

= (12.2% + 6.353868195%) / 2

= 9.28% Approximately

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