Stock in Dragula Industries has a beta of 1.2. The market risk premium is 5 perc

Question

Stock in Dragula Industries has a beta of 1.2. The market risk premium is 5 percent, and T-bills are currently yielding 4.20 percent. The company’s most recent dividend was $1.40 per share, and dividends are expected to grow at a 5.0 percent annual rate indefinitely.

If the stock sells for $30 per share, what is your best estimate of the company’s cost of equity?

Stock in Dragula Industries has a beta of 1.2. The market risk premium is 5 percent, and T-bills are currently yielding 4.20 percent. The company’s most recent dividend was $1.40 per share, and dividends are expected to grow at a 5.0 percent annual rate indefinitely.

Explanation / Answer

RE using dividend cash flow model

30=(1.40*1.05)/(r-0.05)

30=1.47/(r-0.05)

r-0.05=0.049

r=9.90%

RE using CAPM MODEL

RE=4.20%+1.2*5%=10.20%

best estimate=(10.20%+9.90%)/2=10.05%

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