Question

You collected the following data: rate of return on a Treasury bill is 2%, market rate of return is 6%, company's beta is 1.2. Company just paid a dividend of $3.00 per share; and the current stock price is $42. Future dividend growth rate is 4%. 1.Find firm’s cost of equity using the CAPM approach. 2.Find the cost of firm's equity using the DDM approach. 3.Which estimate should you use?

Answer 1

1. As per CAPM, Cost of Equity(Re)= Risk Free Rate+beta*Risk Premium= 2%+1.2*(6%-2%)=2%+4.8%=6.8%

2. As per DDM approach, Stock Price= Dividend*(1+growth rate)/(Required rate of return- growth rate)

i.e. 42= 3*1.04/(Cost of Equity-4%)  

Solving above cost of equity= 11.43%

CAPM model should be used as because in DDM, the constant growth rate and dividend distribution is not ideal in actual scenario. Whereas CAPM model uses the beta (which gives the relation between market and stock return) and risk premium compared to a risk free security which seems more practical. Actually, CAPM gives the risk adjusted return while holding the stock in compare with the risk free security i.e treasury bill.So, CAPM is more practical than DDM.