Eaton Electronic Company’s treasurer uses both the capital asset pricing model a

Question

Eaton Electronic Company’s treasurer uses both the capital asset pricing model and the dividend valuation model to compute the cost of common equity (also referred to as the required rate of return for common equity).

Compute Ki (required rate of return on common equity based on the capital asset pricing model). (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Compute Ke (required rate of return on common equity based on the dividend valuation model). (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

Eaton Electronic Company’s treasurer uses both the capital asset pricing model and the dividend valuation model to compute the cost of common equity (also referred to as the required rate of return for common equity).

Explanation / Answer

a)

required rate of return on common equity based on the capital asset pricing model

required rate of return = Risk free rate of return + beta * (market rate of return - Risk free rate of return )

                                         = 5 + 1.8 *(8 - 5)

                                         = 5 + 5.4

                                         = 10.24%

b)

required rate of return on common equity based on the dividend valuation model

required rate of return = (D1 / P0) + g

                                         = (0.55/16) + 5%

                                         = 3.44%+5%

                                          = 8.44%

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