6. Calculating the Cost of Equity Floyd Industries stock has a beta of 1.15. The

Question

6. Calculating the Cost of Equity Floyd Industries stock has a beta of 1.15. The company just paid a dividend of $.85 (Do), and the dividends are expected to grow at 4.5 percent per year. The expected return on the market is 11 percent, and Treasury bills are yielding 3.9 percent. The most recent stock price for the company is $76. a. Calculate the cost of equity using the Dividend Discount Method b. Calculate the cost of equity using the CAPM (SML) method. c. Why do you think your estimates in (a) and (b) are so different?

Explanation / Answer

Cost of Equity using Dividend Discount Model:

Price of Share = D1/ (Required Return - Growth rate)

D1 = 0.85 * (1 + 4.5%)

76 = 0.85 * (1 + 4.5%)/ (Required Return - 4.5%)

Required Return = 1.17% + 4.5%

Required Return = 5.67%

Cost of Equity using CAPM:

Required Return = Risk Free Rate + Beta * (Market Rate - Risk Free Rate)

Required Rate = 3.9% + 1.15 * (11% - 3.9%)

Required Rate = 12.07%

Required Return = 12.07%

The DDM (Dividend discount model) does not include risk consideration.

On the other side CAPM consider risk in the form of Beta. In addition, DDM assumes dividend growth percentage. SML assumes market risk premium and beta.

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