Question

Stock in Parrothead Industries has a beta of 1.10. The market risk premium is 8 percent, and T-bills are currently yielding 5.5 percent. Parrothead’s most recent dividend was $2.20 per share, and dividends are expected to grow at a 5 percent annual rate indefinitely.

If the stock sells for $32 per share, what is your best estimate of Parrothead’s cost of equity?


Use the dividend growth model and SML or CAPM method.

Answer 1

13.26%

Step-by-step explanation:

For computing the best estimate, first we have to determine the expected rate of return by using the CAPM model which is shown below:

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

= 5.5% + 1.10 × 8%

= 5.5% + 8.8%

= 14.3%

The Market rate of return - Risk-free rate of return) is also known as the market risk premium and the same is applied.

Now under the dividend growth model, the cost of equity would be

Price = Next year dividend ÷ (Required rate of return - growth rate)

where,

the next year dividend would be

= $2.20 + $2.20 × 5%

= $2.20 + 0.11

= $2.31

The other items rate would remain same

Now put these values to the above formula

So, the value would equal to

$32 = $2.31 ÷ (Cost of equity - 5%)

After solving this, the cost of equity would be 12.22%

Now the best estimated would be

= (14.3% + 12.2%) ÷ 2

= 13.26%