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28 September, 15:21

Stock in Parrothead Industries has a beta of 1.10. The market risk premium is 8 percent, and T-bills are currently yielding 5.5 percent. Parrothead's most recent dividend was $2.20 per share, and dividends are expected to grow at a 5 percent annual rate indefinitely.

If the stock sells for $32 per share, what is your best estimate of Parrothead's cost of equity?

Use the dividend growth model and SML or CAPM method.

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  1. 28 September, 17:53
    0
    13.26%

    Explanation:

    For computing the best estimate, first we have to determine the expected rate of return by using the CAPM model which is shown below:

    Expected rate of return = Risk-free rate of return + Beta * (Market rate of return - Risk-free rate of return)

    = 5.5% + 1.10 * 8%

    = 5.5% + 8.8%

    = 14.3%

    The Market rate of return - Risk-free rate of return) is also known as the market risk premium and the same is applied.

    Now under the dividend growth model, the cost of equity would be

    Price = Next year dividend : (Required rate of return - growth rate)

    where,

    the next year dividend would be

    = $2.20 + $2.20 * 5%

    = $2.20 + 0.11

    = $2.31

    The other items rate would remain same

    Now put these values to the above formula

    So, the value would equal to

    $32 = $2.31 : (Cost of equity - 5%)

    After solving this, the cost of equity would be 12.22%

    Now the best estimated would be

    = (14.3% + 12.2%) : 2

    = 13.26%
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