5. (calculating the cost of common stock, or common equity per the dividend grow
ID: 2715654 • Letter: 5
Question
5. (calculating the cost of common stock, or common equity per the dividend growth model approach) Your firm’s common stock is selling for $37.00 a share and it paid a dividend last year to the common stockholders of $1.60. If the growth rate in earnings and dividends for your firm is estimated to be a constant 5% for the foreseeable future, what is your firm’s cost of common equity per the dividend growth model approach?
6. (cost of common stock, or common equity per the CAPM approach) After some research on the Internet, you determine that the risk-free rate (as measured by ten-year treasury bonds) is 2.34%. You also determine that analysts believe the average rate of return on the stock market as a whole is 9.0%. Your firm has a beta of 1.1. Given these conditions, what is your firm’s what is your firm’s cost of common equity per the CAPM approach?
7. (determining the final cost of common equity) Given your answers to questions 5 and 6 above, what is your final estimate of your firm’s cost of common equity?
8. (calculating the WACC) Given your answers to questions 3, 4, and 7 above, what is your estimate of your estimate of your firm’s weighted average cost of capital if it wishes to maintain a capital structure of 40% debt,10% preferred stock, and 50% common equity?
Explanation / Answer
5.
Ke = D1 / P0 + g Where, Ke= Cost of Equity
D1 = Dividend next year
P0 = Current Price per share
g = growth rate
Ke = [(1.6*1.05)/37]+ 0.05 = 9.54%
Cost of Equity = 9.54%
6.
Cost of Equity(CAPM) = Risk free rate + [Beta of Stock*(Market Return - Risk free return)]
= 2.34 + [1.1*(9-2.34)]
= 9.666%
7.
The final estimate of firm's cost of common equity
= [Cost of Equity as per Dividend Growth model + Cost of Equity of Equity as per CAPM]/2
= [9.54+9.666]/2 = 9.603%
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