The PMBA Corp (beta = 1.3) is trying to determine it cost of equity. You have be

Question

The PMBA Corp (beta = 1.3) is trying to determine it cost of equity. You have been asked to give the cost of equity using a variety of methods. The methods to be used are the CAPM, and the DCF model. The risk free rate is 2.00%, and the risk premium on the market is 5.50%. The stock is expected to pay a dividend of $3.00 next year, the stock is trading at $100 per share, the return on equity is 12% and the retention ratio is 80%. You have been told the return for the Small sized portfolio minus the bid-sized portfolio is 3.00%, and the slope coefficient is .3, the high book to market portfolio minus the low book to market value portfolio is -2.00% and the factor weighting (slope) is .4. Calculate the three costs on equity. Explain the different in the results.

Explanation / Answer

Cost of equity Under CAPM method

Cost of Equity = Risk-Free Rate + Beta * (Market Rate of Return - Risk-Free Rate)

= 2 + 1.3* (12 - 2)

= 15 %

Cost of equity under Dividend growth model/ DCF method

Cost of equity = (Next Year's Annual Dividend / Current Stock Price) + Dividend Growth Rate

=($ 3/ $100) + 3%

= 6 %

Dividend discount model for estimation of cost of equity is useful only when the stock is dividend-paying. In reality, we have a lot of stocks that do not pay dividends. In such situations, the capital asset pricing model and some other more advanced models are used.

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