Question

Kmart shares have a beta of 1.05. The company has just paid a dividend of $1.10, and the dividends are expected to grow at 2.5%. The expected return of the market is 9% and the risk-free rate is 1.5%. The most recent share price for Kmart’s shares is $51.

a. Calculate the cost of equity using the dividend growth model method. (10)

b. Calculate the cost of equity using the SML method. (10)

c. Why do you think your estimates in a and b are so different? (5)

Answer 1

Share Price (P0) = $ 51

Dividend (D0) = $ 1.10

Growth in dividends (g) = 2.5 %

Let Cost of equity be ke

a)

Using Dividend growth model,

P0 = D0*(1+g) / (k-g)

51 = 1.1 *(1+2.5%)/(ke - 2.5%)

ke - 2.5% = 2.22 %

ke = 4.71%

b)

Using SML,

Risk free rate = 1.5%

Beta = 1.05

Market risk premium = 9 - 1.5% = 7.5%

Required rate of return using CAPM, ke = 1.5% + 1.05* 7.5% = 9.375 %

c)

The estimates using CAPM are theoretical and is what is required as per the Beta or the systematic risk of the firm,while the dividend growth model is based on actual market price being traded in the market which could either be over valued or undervalued (in this case overvalued). Hence the market is seen to be not commanding the required premium as per the risk of the stock.