Stock in Globex Corporation has a beta of 0.9. The expected market return is 10%, and T-bills are currently yielding 3.5%. The company's next dividend is expected to be $2 per share, and dividends
Have been growing at a 4% annual rate. If the stock sells for $25 per share, what is your best
Estimate of the company's cost of equity?

Question

Quizplus · Accepted Answer

First, we need to calculate the expected dividend for next year: 
Expected Dividend = $2 x (1 + 0.04) = $2.08

Next, we can use the dividend discount model to calculate the cost of equity: 
Cost of Equity = (Expected Dividend/Stock Price) + Expected Growth Rate

Cost of Equity = ($2.08/$25) + 0.04 = 0.0832 + 0.04 = 0.1232 or 12.32%

However, this is the nominal cost of equity. To adjust for inflation, we need to subtract the risk-free rate (T-bill rate) from the nominal cost of equity:

Real Cost of Equity = Nominal Cost of Equity - Risk-Free Rate 
Real Cost of Equity = 0.1232 - 0.035 = 0.0882 or 8.82%

Therefore, the best estimate of the company's cost of equity is 10.68% (nominal) or 8.82% (real), which is option B).

Stock in Globex Corporation Has a Beta of 0