2. The earnings, dividends and stock price of a company are expected to grow at

Question

2. The earnings, dividends and stock price of a company are expected to grow at 4 percent per year in the future. Its common stock sells for $ 4.80 per share and its last dividend was $ 0.25 a. Using the discounted cash flow approach, what is it’s the company’s cost of equity? b. If the company’s beta is 1.25, the risk-free rate is 3 % and the market risk margin is 5%, what is its company’s cost of equity based on the capital asset pricing model approach? c. What would be your estimate of the company’s cost of equity after calculate different results of the same parameter in a) and b)? Do your research, and explain and use citation.

Explanation / Answer

(a) DISCOUNTED CASH FLOW APPROACH

Price of the stock = D0(1+g) / Ke – g

Where, Price of the stock = $ 4.80

D0 = Last year Dividend = $ 0.25

G = growth rate = 4%

Ke = cost of equity

$ 4.80 = (0.25 x 1.04) / Ke - 0.04

Ke – 0.04 = $ 0.26 / $ 4.80

Ke – 0.04 = 0.05417

Therefore, Ke = 9.42%

(b) CAPITAL ASSET PRICING MODEL APPROACH

Ke under capital asset pricing model approach = Rf + Beta (Rm – Rf )

Where, Rf = Risk Free rate = 3 %

Beta = 1.25

Rm-Rf = Risk Premium = 5 %

Ke = 3% + (1.25 x 5% )

Ke = 9.25%

(c) Company’s Cost of equity under Discounted Cash Flow Approach = 9.42%

      Company’s Cost of equity under Capital Asset Pricing Model Approach = 9.25%

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