Question

Gabriel Industries stock has a beta of 1.12. The company just paid a dividend of $1.15, and the dividends are expected to grow at 4 percent. The expected return on the market is 11.4 percent, and Treasury bills are yielding 3.8 percent. The most recent stock price is $85. (a) Calculate the cost of equity using the dividend growth model method. (b) Calculate the cost of equity using the SML method. (c) Why do you think your estimates in (a) and (b) are so different?

Answer 1

Answer and Explanation:

a. The computation of cost of equity using the dividend growth model method is shown below:-

Expected Dividend = Current dividend × (1 + Growth rate)

= $1.15 × (1.04)

= $1.196

Current Stock Price = $85

Cost of Equity = (Expected dividend ÷ Current stock price) + growth rate

= (1.196 ÷ 85) + 0.04

= 0.05407

or

= 5.41 %

b. The computation of cost of equity using the SML method is shown below:-

Using CAPM, Cost of Equity = Risk free rate + Stock beta × (Market return - Risk free rate)

= 3.8 + 1.12 × (11.4 - 3.8)

= 12.31%

c. Since there are two different methods like SML and dividend growth model for determining the cost of equity so the estimates are so different