Question

# 8 San Diego Gas and Electronic Company’s treasurer uses both the capital asset pricing model and...

8

San Diego Gas and Electronic Company’s treasurer uses both the capital asset pricing model and the dividend valuation model to compute the cost of common equity (also referred to as the required rate of return for common equity).

Assume: Rf = 6 % Km = 9 % β = 2.2 D1 = \$ .70 P0 = \$ 15 g = 6 %

a. Compute Ki (required rate of return on common equity based on the capital asset pricing model). (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

b. Compute Ke (required rate of return on common equity based on the dividend valuation model). (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

(a)-Required rate of return on common equity based on the capital asset pricing model

As per CAPM Approach, the Required Rate of Return is calculated as follows

Required Rate of Return = Risk-free Rate + Beta(Market Rate of Return – Risk-free Rate) - x Market Risk Premium)

= 6.00% + 2.2(9.00% - 6.00%)

= 6.00% + (2.2 x 3.00%)

= 6.00% + 6.60%

= 12.60%

(b)-Required rate of return on common equity based on the dividend valuation model

The Required rate of return on common equity based on the dividend valuation model is calculated as follows

Required rate of return = (D1 / P0) + g

Here, Next year Dividend (D1) = \$0.70 per share

Current Share Price (P0) = \$15.00 per share

Dividend Growth Rate (g) = 6% per year

Therefore, the Required rate of return = (D1 / P0) + g

= [\$0.70 / \$15.00] + 0.06

= 0.0467 + 0.06

= 0.1067 or

= 10.67%

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