Question

Stock in BCD Industries has a beta of .90.  The market risk premium is 7%, and the risk-free rate is 3.5%.  BCD’s most recent dividend was $1.80/share and the dividends are expected to grow at 5% annual indefinitely.  The current price is $47/share.

What is the cost of equity using the best estimate method?

Answer 1

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1. As per CAPM model:

Re= Rf+(Rm-Rf)B

Re= required rate of return or cost of equity.

Rf= Risk-free rate.

Rm = return on the market.

Rm-Rf =Market Risk Premium.

B = Beta, systematic risk.

Re= 3.5%+(7%)0.90

CAPM COST OF EQUITY = 9.8%

2. DDM COST OF EQUITY:

As per Gordon Growth Model of Stock Valuation:

P=Do(1+g)/(Re-g)

P= price of the share.

Do= most recent dividend

g= Growth rate

Re= required rate of return or cost of equity.

47=1.80*(1.05)/(Re-0.05)

DDM COST OF EQUITY (Re) = 9.02%