Question

Rossdale Co. stock currently sells for $68.69 per share and has a beta of .87. The market risk premium is 7.30 percent and the risk-free rate is 2.89 percent annually. The company just paid a dividend of $3.53 per share, which it has pledged to increase at an annual rate of 3.20 percent indefinitely. What is your best estimate of the company's cost of equity?

Answer 1

8.5%

Step-by-step explanation:

we can calculate the company's cost of equity in two different ways:

Re = risk free rate + (beta x market risk premium) = 2.89% + (0.87 x 7.3%) = 9.24%

or

we can use the dividend growth model

P₀ = Div₁ / (Re - g)

Re - g = Div₁ / P₀

Re = Div₁ / P₀ + g

• Div₁ = $3.53 x 1.032 = $3.64296
• P₀ = $68.69
• g = 3.2%

Re = $3.64296/$68.69 + 3.2% = 8.5%

Personally, I would consider the second calculation to be more exact since the market knows better.