Stock in Dragula Industries has a beta of 1.3. The market risk premium is 6 perc

Question

Stock in Dragula Industries has a beta of 1.3. The market risk premium is 6 percent, and T-bills are currently yielding 5.00 percent. The company’s most recent dividend was $2.00 per share, and dividends are expected to grow at a 8.0 percent annual rate indefinitely.

If the stock sells for $36 per share, what is your best estimate of the company’s cost of equity? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

If the stock sells for $36 per share, what is your best estimate of the company’s cost of equity? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Explanation / Answer

Expected return = Rf+×Rp

Rf is risk free return

Rp is risk premium

= 5%+1.3×6%

= 12.8%

Stock price = D1÷(r-g)

D1 is next expected dividend

r is required return

g is growth rate

$36 = $2×(1+8%)÷(r-8%)

Required return = 14%

Best estimate = (14%+12.8%)÷2

= 13.4%

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