Question

Minder Industries stock has a beta of 1.08. The company just paid a dividend of $.65, and the dividends are expected to grow at 4 percent. The expected return on the market is 10.5 percent, and Treasury bills are yielding 3.4 percent. The most recent stock price for the company is $72. a. Calculate the cost of equity using the DCF method. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) b. Calculate the cost of equity using the SML method. (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g, 32.16.) a. DCF method b. SML method

Answer 1

a. The cost of equity using the DCF method is 4.90%. b. The cost of equity using the SML method is 11.07%.

Step-by-step explanation:

a. In order to calculate the cost of equity using the DCF method, we need to use the formula:

Cost of Equity = Dividend / Stock Price + Growth Rate

Substituting the given values into the formula, we get:

Cost of Equity = $0.65 / $72 + 0.04 = 0.0090278 + 0.04 = 0.0490278 = 4.90%

Therefore, the cost of equity using the DCF method is 4.90%.

b. In order to calculate the cost of equity using the SML method, we need to use the formula:

Cost of Equity = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)

Substituting the given values into the formula, we get:

Cost of Equity = 0.034 + 1.08 * (0.105 - 0.034) = 0.034 + 1.08 * 0.071 = 0.034 + 0.07668 = 0.11068 = 11.07%

Therefore, the cost of equity using the SML method is 11.07%.

Answer 2

Cost of Equity:

DCF = 4.94%

SML = 11.07%

Equity capital is the capital provider by ordinary shareholders. The cost of equity is the minimum return on capital required by the ordinary shareholders.

The cost of equity can calculated using the

1. capital asset pricing model (SML)
2. Dividend valuation model

The Discounted Cash flow (DCF) Model; This is a technique used to value the worth of an asset. According to this model, the value of an asset is the sum of the present values of the future cash flows that would arise from the asset discounted at the required rate of return. Using this model,

cost of equity (Ke) =( D(1+g)/P) + g

Div in year 0, P= ex-div market price, g= growth rate in div.

For this question,

Ke= ( 0.65(1+0.04)/72 ) + 0.04

=0.049 × 100

= 4.94%

The capital asset pricing model is a risk-based model. Here, the return on equity is dependent on the level of reaction of the the equity to changes in the return on a market porfolio. These changes are captured as systematic risk. The magnitude by which a stock is affected by sysematic risk is measured by beta.

Under CAPM, Ke= Rf + β(Rm-Rf)

Rf-risk-free rate (treasury bill rate), β= Beta, Rm= Return on market.

Using this model,

Ke= 3.4% + 1.08(10.5%-3.4%)

= 11.07%