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

Answer 1

a. Under DCF method, the cost of equity is 4.945

b. The cost of equity under SML is 11.07%

Step-by-step explanation:

a.

The DCF method values the stock based on the present value of the future expected dividends. The price per share for a stock whose dividends are expected to grow at a constant rate is calculated as follows,

P0 = D0 * (1+g) / r - g

We, know the price today, the growth rate in dividends and D0. Plugging in these values in the formula, we calculate r to be,

72 = 0.65 * (1+0.04) / (r- 0.04)

72 * (r-0.04) = 0.676

72r - 2.88 = 0.676

72r = 0.676 + 2.88

r = 3.556 / 72

r = 0.04938 or 4.938% rounded off to 4.94%

b.

The SML approach is used to calculate the required rate of return or cost of equity of a stock based on the stock's beta, the risk free rate and the market risk premium. The formula for r under this method is,

r = rRF + Beta * (rM - rRF)

Where,

• rRF is the risk free rate or t bills rate
• rM is the expected return on market

r = 0.034 + 1.08 * (0.105 - 0.034) = 0.11068 or 11.068% rounded off to 11.07%