Calculating the Cost of Equity Suppose stock in Watta Corporation has a beta of .80. The market risk premium is 6 percent, and the risk-free rate is 6 percent.

Question

Calculating the Cost of Equity Suppose stock in Watta Corporation has a beta of .80. The market risk premium is 6 percent, and the risk-free rate is 6 percent. Watta’s last dividend was $1.20 per share, and the dividend is expected to grow at 8 percent indefinitely. The stock currently sells for $45 per share. What is Watta’s cost of equity capital?

Accepted Answer

We start off with the SML approach. Based on the information given, the expected return on Watta’s common stock is:

[latex]R_{E}=R_{f}+β_{E}×(R_{M}-R_{f})[/latex]

=6%+.80×6%

=10.80%

We now use the dividend growth model. The projected dividend is [latex]D_{0}× (1+g)[/latex]=$1.20×1.08=$1.296, so the expected return using this approach is:

[latex]R_{E}=D_{1}/P_{0}+g[/latex]

=$1.296/45+.08

=10.88%

Because these two estimates, 10.80 percent and 10.88 percent, are fairly close, we will average them. Watta’s cost of equity is approximately 10.84 percent.

Question 14.S-T.1: Calculating the Cost of Equity Suppose stock in Watta Corpor...

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