Question

Stock in ABC Enterprises has a beta of 1.28. The market risk premium is 7.4 percent, and T-bills are currently yielding 3.6 percent. ABC's most recently paid dividend was $1.62 per share, and dividends are expected to grow at an annual rate of 2 percent indefinitely. If the stock sells for $38 a share, what is your best estimate of ABC's cost of equity? 9.71 percent 9.41 percent 9.78 percent 7.82 percent 7.41 percent (Please Show Work)

Answer 1

9.71 percent

Step-by-step explanation:

The computation is shown below:

Cost of equity based on CAPM model

Expected rate of return = Risk-free rate of return + Beta × (Market rate of return - Risk-free rate of return)

= 3.6% + 1.28 × 7.4%

= 3.6% + 9.472%

= 13.07%

Cost of equity based on Dividend model

= Current year dividend ÷ price + Growth rate

where,

The current dividend would be

= $1.62 + $1.62 × 2%

= $1.62 + $0.0324

= $1.6524

The other things would remain the same

So, the cost of common equity would be

= $1.6524 ÷ $38 + 2%

= 0.04348 + 0.02

= 6.35%

So, the best estimate would be the average which is shown below:

= (13.07% + 6.35%) ÷ 2

= 9.71%