Question

Southern Home Cookin' just paid its annual dividend of $.70 a share. The stock has a market price of $31 and a beta of 1.1. The return on the U.S. Treasury bill is 4 percent and the market risk premium is 13 percent. What is the cost of equity?

Answer 1

Cost of equity = 18.3%

Step-by-step explanation:

The Capital Asset pricing model (CAPM) establishes the relationship between the expected return on a stock and the systematic risk. The systematic risk which is represented by beta is used to measure the volatility of the stock relative to risks that affect the entire market.

The model is given below and can be used to calculated the cost of equity

E(r) = Rf + β× (Rm-Rf)

E(r)m - cost of equity

Rf- Risk-free rate

β- Beta

Rm-Rf - risk premium

Rf = 4% , β- 1.1, Rm-Rf = risks premium- 13%

E(r) = 4% + (1.1× 13)%

= 18.3%

Cost of equity = 18.3%

Note that this model is preferred to the dividend valuation model because it considers risk which is a very key factor investment decision