Question

Floyd Industries stock has a beta of 1.30. The company just paid a dividend of $.30, and the dividends are expected to grow at 4 percent per year. The expected return on the market is 13 percent, and Treasury bills are yielding 4.5 percent. The most recent stock price for Floyd is $62.

a. Calculate the cost of equity using the DDM method.b. Calculate the cost of equity using the SML method.

Answer 1

Answer:

a. Cost of Equity is 4.50%

b. Cost of Equity is 15.55%

Explanation:

a.

The formula for price of a stock using the constant growth model of the DDM approach is,

P0 = D0 * (1+g) / r - g

Plugging in the available values,

62 = 0.3 * (1+0.04)  /  (r - 0.04)

62 * (r - 0.04) = 0.312

62r - 2.48 = 0.312

62r = 0.312 + 2.48

r = 2.792 / 62

r = 0.045 or 4.5%

b.

SML (r) = rRF + β * (rM - rRF)

Plugging in the values,

r = 0.045 + 1.3 * ( 0.13 - 0.045)  

r = 0.1555 or 15.55%