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.

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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answer; 20% is your answer;