Question

Musical Charts just paid an annual dividend of $1.84 per share. This dividend is expected to increase by 2.1 percent annually. Currently, the firm has a beta of 1.12 and a stock price of $31 a share. The risk-free rate is 4.3 percent and the market rate of return is 13.2 percent. What is the cost of equity capital for this firm?

Answer 1

Answer:

According to CAPM:

Requires Return = Risk free rate + Beta * (market rate of return – risk free rate)
Required Return = 0.043 + 1.12 * (0.132 – 0.043)
Required Return = 0.043 + 1.12 * 0.089
Required Return = 0.043 + 0.0997
Required Return = 0.1427 or 14.27%

According to Dividend Growth Model:

D1 = D0 * (1 + g)
D1 = $1.84 * (1 + 0.021)
D1 = $1.84 * 1.021
D1 = 1.8786

Required Return = D1 / P0 + g
Required Return = $1.88 / $31 + 0.021
Required Return = 0.0606 + 0.021
Required Return = 0.0816 or 8.16%

Average of two required return, the cost of equity capital = (Required Return of CAPM + Required Return to Dividend Growth Model) /2
Average of two required return, the cost of equity capital = (14.27% + 8.16%)/2
Average of two required return, the cost of equity capital = 11.22%