Wednesday, January 4, 2012

Calculating Cost of Equity

Calculating the Cost of Equity – Floyd industries stock has a beta of 1.50. the company just paid a dividend of $0.80, and the dividend expected to grow at 5 percent per year. The expected return on the market is 12 percent, and Treasury bills are yielding 5.5 percent. The most recent stock price for  Floyd is $61.
Calculate the cost of equity using the DDM method.
Calculate the cost of equity using SML method.
Why do you think your estimates in (a) and (b) are so different?

a.       Using  the dividend discount model, the cost of equity is:

RE = Div/P + g

Div = dividend per share to be received next year = $0.80 + ($0.80*5%) = $0.84
P = the price per share of a stock = $61
g = the constant annual growth rate in dividend per share = 5%

RE = Div/P + g
RE  = ($0.84/$61) + 5%
RE  = 0.0638 = 6.38%

b.      Using the CAPM, the cost of equity is:

RE = RF + β (RM – RF)

(RM – RF) = the different between the expected return on the market portfolio and the riskless rate = 12% - 5.5% = 6.5%

β  = Beta = 1.50
RF = the risk – free rate = 5.5%

RE = RF + β (RM – RF)
RE = 5.5% + 1.50 (6.5%)
RE = 0.1525 or 15.25%

Reference: Corporate Finance Book, Stephen A.Ross, Randolph W.Westerfield and Jeffrey Jaffe, Ninth Edition. Chapter 13, questions and problems  number 21  page 424.


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