A firm has a return on equity of 12.4 per cent according to the dividend growth model and a return of 18.7 per cent according to the capital asset pricing model.The market rate of return is 13.5 per cent.What rate should the firm use as the cost of equity when computing the firm's WACC?

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Quizplus · Accepted Answer

The firm should use the arithmetic average of the two estimates, 12.4% and 18.7%, which is 15.55%. This is a more conservative approach as it takes into account both the dividend growth model and the capital asset pricing model, rather than relying on just one method. Using the market rate of return (13.5%) would also be too low since it does not reflect the firm's specific risk and return characteristics.

A Firm Has a Return on Equity of 12