Floyd Industries stock has a beta of 1.25. The company just paid a dividend of $.40 and the dividends are expected to grow at 5 percent per year. The expected return on the market is 12 percent, and Treasury bills are yielding 6.1 percent. The most recent stock price for the company is $78.

(a) Calculate the cost of equity using the DDM method. (Round your answer to 2 decimal places. (e. g., 32.16)).

(b) Calculate the cost of equity using the SML method. (Round your answer to 2 decimal places. (e. g., 32.16)).

a. The cost of equity is 5.538%

b.The cost of equity is 13.475%

Explanation:

a.

The DDM approach has several models that are used to calculate the price of the share. As the dividend growth is constant forever, we use the constant growth model of DDM to estimate the required rate of return or cost of equity as other variables are known.

The formula for price using the constant growth model is:

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

Plugging in the value,

78 = [0.4 * (1+0.05)]  /  (r - 0.05)

78 * (r - 0.05) = 0.42

78r - 3.9 = 0.42

78r = 3.9 + 0.42

r = 4.32 / 78

r = 0.05538 or 5.538%

b.

The SML approach uses the risk free rate and market risk premium along with stock's beta to calculate the cost of equity or required rate of return.

The cost of equity using SML is:

r =  0.061 + 1.25 * (0.12 - 0.061)

r = 0.13475 or 13.475%

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