The MacBurger Company, a chain of fast-food restaurants, expects to ea

QUESTION

The MacBurger Company, a chain of fast-food restaurants, expects to earn $200 million after taxes for the current year. The company has a policy of paying out half of its net after-tax income to the holders of the companys 100 million shares of common stock. A share of common stock of the company currently sells for eight times current earnings. Management and outside analysts expect the growth rate of earnings and dividends for the company to be 7.5 percent per year. Calculate the cost of equity capital to this firm.
Solution: Net profit after taxes = $200 million Dividend Payout = 50% of net profit after taxes Dividend Paid = $100 million Common stock = 100 million shares Dividend per share (Do) = $100 million / 100 million shares = $ 1 per share EPS = $200 million / 100 million share = $2 per share Price to earnings ratio(P/E) = 8 times Growth rate of earnings and dividends (g) = 7.5% According to Gordon Dividend Discount Model Price of share = Do * (1 + g) / (cost of equity “ g) Hence¦

P/E ratio = Price / Earning per share = [Do * (1 + g) / (cost of equity “ g)] / EPS Given P/E = 8 Or, [Do * (1 + g) / (cost of equity “ g)] / EPS = 8 Or, [$1 * (1+0.075) / (cost of equity “ 0.075)] / $2 = 8 Or,[$1 * (1+0.075) / (cost of equity “ 0.075)]= $16 Or, 0.067 = Cost of Equity “ 0.075 Or, Cost of Equity = 14.2%

ANSWER:

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