Restless.com has an 8% rate of interest on newly issued bonds. The firm has a return on equity of 13.33% and a dividend payout ratio of 40%; the last dividend paid was $1.50, and the firm’s shares sell for $26. The stock’s beta is 1.7, the expected return on the market portfolio is 11%, and the riskfree rate of interest is 6%. If the appropriate risk premium relative to the bond yield is 5% for a dot-com, estimate Restless.com’s cost of equity capital using the bond yield plus risk premium (BY + RP), the dividend discount model (DDM) and the capital asset pricing model (CAPM), respectively. The firm is/in a 35% marginal tax bracket. BY + RP DDM CAPM A. 10.2% 14.2% 24.7% B. 10.2% 11.4% 13.5% C. 13.0% 14.2% 14.5% D. 13.0% 13.2% 13.5% Answer C How do you get the DDM?
DDM --> 1 form D1/(k-g)=P g = ROE * RR = 13.33 * .6 = 8% So k = D1/P + g = 1.5 * 1.08 / 26 + .08 = .062 + .08 = 14.2%
I’m too lazy to do it now, but use the retention rate (1 - dividend payout) to get Growth with CAPM to get required rate of return. That is the start, this is a long tough problem no doubt.
ROE=13.33, RR (retention rate)=1-0.4=0.6, growth would be g=ROE*RR=8% Then, with the DDM, Ke=1.5*1.08/26 + 0.08=14.23~14.2