Phillip Enterprises Inc. needs to determine its cost of equity capital

Phillip Enterprises Inc. needs to determine its cost of equity capital. Use the following information to estimate the firm’s cost of equity using both the security market line and the dividend growth model.

The current market price of stock is $22.89, the risk-free rate is 4.00%, the required return on the market portfolio is 13.50%, the firm has a constant growth rate in dividends of 3.00% per year, current dividends are $2.00, and the firm’s beta is 0.90.
What will be an ideal response?

ANSWER

Answer: For the dividend growth model, Re = + g = + .03 = 12.00%
For the SML, E(ri) = rf + [E(rm) – rf] βi = 0.04 + (.135 – .04) × 0.90 = 12.55%.
At this point, the student may choose either answer or to average the two answers.