Question

Golden State Home Health, Inc., is a large, California-based for-profit home health agency. Its dividends are expected to grow at a constant rate of 5 percent per year into the foreseeable future. The firm's last dividend (Do) was $1, and its current stock price is $10. The firm's beta coefficient is 1.2 ; the rate of return on 20-year T-bonds currently is 4 percent; and the expected rate of return on the market, as reported by a large financial services firm, is 8 percent. Golden State's target capital structure calls for 60 percent debt financing, the interest rate required on its new debt is 9 percent, and the firm's tax rate is 30 percent. What is the firm's cost-of-equity estimate according to the DCF method?

Answer 1

The cost of equity for Golden State Home Health, Inc., according to the Dividend Discount Model (DCF), can be calculated to be 15.5%, taking into account a dividend growth rate of 5% and a current stock price of $10.

Step-by-step explanation:

The student has asked to estimate Golden State Home Health, Inc.'s cost of equity using the Dividend Discount Model (DCF), which is a method for valuing a company based on the theory that a stock is worth the sum of all its future dividend payments, discounted back to their present value.

This method is applied since the company's dividends are expected to grow at a constant rate. The cost of equity is one of the key components used in the Capital Asset Pricing Model (CAPM).

To calculate the cost of equity using the DCF method:

Cost of Equity = (D1 / P0) + g

Where:
D1 = Expected dividend next year
P0 = Current stock price
g = Growth rate of dividends.

Given that the company's last dividend (Do) was $1 and is expected to grow at 5% (g = 0.05), the expected dividend next year D1 would be $1.05. With a current stock price (P0) of $10, the cost of equity can be calculated as follows:

Cost of Equity = (1.05 / 10) + 0.05 = 0.155 or 15.5%