Respuesta :
Answer:
The best estimate of the company’s cost of equity is 9.81 %.
Explanation:
Use both the Growth Model and the Capital Asset Pricing Model (CAPM) to estimate the cost of equity and find the average.
Cost of Equity (Growth Model) = Recent Dividend Payout Ratio/ Market Price of Stock + Expected Growth
= $2.05 / $39.00 + 0.041
= 9.36 %
Cost of Equity (CAPM) = Return on Risk Free Security + Beta × Risk Premium
= 3.60 % + 0.95 × 7.00 %
= 10.25 %
Average = (9.36 % + 10.25 %) ÷ 2
= 9.81 %
The cost of equity of a company is 9.875% after taking the average of the cost of equity by the CAPM approach and the cost of equity by the Dividend growth model.
What is meant by the cost of equity?
The cost of equity is the percentage of return earned by a stock investor by making an investment.
Given values for CAPM Approach:
A beta factor of stock: 0.95
Market risk premium: 7%
Return on T-bills: 3.6%
Step-1 Computation of cost of equity by using the CAPM approach:
[tex]\rm\ Cost \rm\ of \rm\ Equity=\rm\ Return \rm\ on \rm\ T-Bills + (\rm\ Market \rm\ Risk \rm\ Premium \times\ \rm\ Beta \rm\ Factor) \\\rm\ Cost \rm\ of \rm\ Equity= 3.6\% + (7\% \times 0.95)\\\rm\ Cost \rm\ of \rm\ Equity=10.25\%[/tex]
Given values for dividend growth approach:
Dividend rate: $2.05
Expected growth in dividend: 4.1 %
Stock price: $39
Step-2 Computation of cost of equity by using the dividend growth approach:
[tex]\rm\ Cost \rm\ of \rm\ Equity=\frac{\rm\ Dividend \rm\ Rate \times\ (1+ \rm\ Growth\rm\ Rate)}{\rm\ Stock \rm\ price} + \rm\ Growth \rm\ rate\\\rm\ Cost \rm\ of \rm\ Equity=\frac{\$2.05 \times\ (1+ 0.041)}{ \$39} + 0.041\\\rm\ Cost \rm\ of \rm\ Equity=\frac{\$2.13 }{\$39} + 0.041\\\rm\ Cost \rm\ of \rm\ Equity=9.50\%[/tex]
Step-3 Computation of average of both methods:
[tex]\rm\ Average \rm\ Cost \rm\ of \rm\ Equity= \frac{\rm\ Cost \rm\ of \rm\ Equity \rm\ in \rm\ CAPM \rm\ Method + \rm\ Cost \rm\ of \rm\ Equity \rm\ in \rm\ Dividend \rm\ growth}{2}\\\rm\ Average \rm\ Cost \rm\ of \rm\ Equity=\frac{10.25\% + 9.50\%}{2} \\\rm\ Average \rm\ Cost \rm\ of \rm\ Equity=9.875\%[/tex]
Therefore, the cost of equity comes out to be 9.875% by using the average of the two methods.
Learn more about the cost of equity in the related link:
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