Final answer:
The student's question on calculating the cost of equity can be approached by two methods: CAPM and DDM. Using CAPM, the cost of equity is 12.08%. Using DDM, it's 10.22%. The best estimate would likely be considered between these two, or a more accurate estimate may be determined with additional data or expert analysis.
Step-by-step explanation:
To estimate a company's cost of equity, one method is the Capital Asset Pricing Model (CAPM), which incorporates risk and return. The formula is:
Cost of Equity = Risk-Free Rate + Beta × Market Risk Premium
Given the data:
Risk-Free Rate (T-bill yield) = 3.5%,
Beta = 1.10,
Market Risk Premium = 7.8%,
Cost of Equity = 3.5% + 1.10 × 7.8%
= 3.5% + 8.58%
= 12.08%.
Alternatively, the Dividend Discount Model (DDM) can also be used, with the formula:
Cost of Equity = (Dividend Per Share / Price Per Share) + Growth Rate of Dividends
Given the data:
Recent Dividend = $2.35,
Growth Rate = 5%,
Price Per Share = $45,
Cost of Equity = ($2.35 / $45) + 5%
= 0.0522 + 5%
= 5.22% + 5%
= 10.22%.
In this scenario, the best estimate for the company's cost of equity would likely be considered between these two methods, or specifically additional market data or expert financial analysis would be used to determine the most accurate estimate based on the context and market conditions.