EXAMPLE 12.1 The Cost of Equity Suppose stock in Alpha Air Freight has a beta of 12. The market risk premium is 8 percent, and the risk-free rate is 6 percent. Alpha's last dividend was $2 per share, and the dividend is expected to grow at 8 percent indefinitely. The stock currently sells for $30. What is Alpha's cost of equity capital? We can start off by using the SML. Doing this, we find that the expected return on the common stock of Alpha Air Freight is: R₂=R₁+₂xR-R) -6% +12 x 8% <= 15.6% This suggests that 15.6 percent is Alpha's cost of equity. We next use the dividend growth model. The projected dividend is D₂ x (1 + g) - $2 x 1.08 = $2.16, so the expected return using this approach is: R=D/P+9 -$216/30+.08 = 15.2% Our two estimates are reasonably close, so we might just average them to find that Alpha's cost of equity is approximately 15.4 percent. O EXAMPLE 12.1 page 294 6-1.2 Rm 8% Rs = 6% Po $30 - 8% a "#2 ⒸJML Samity market Line RE RE [6 (RM-RF) =.00+ [ 1.2 (108) =.06+ [ 3 =2136 = 115.6% Ⓒ Div Reinvest model R = Po +3 2116 + 08 34 V .066 7.08 152 Isa To 2x Lof-0.16 3 Aug 15.6. SML DRM 1 = 154% 15 2 WACC weighted Aug cost of Capital - 15.4% what the company must earn to compensate their investors for their money Rm= market risk annoted as -08- Rm. ·10 = Rm = Required Return premium Rm-RF -02
Dividend Valuation
Dividend refers to a reward or cash that a company gives to its shareholders out of the profits. Dividends can be issued in various forms such as cash payment, stocks, or in any other form as per the company norms. It is usually a part of the profit that the company shares with its shareholders.
Dividend Discount Model
Dividend payments are generally paid to investors or shareholders of a company when the company earns profit for the year, thus representing growth. The dividend discount model is an important method used to forecast the price of a company’s stock. It is based on the computation methodology that the present value of all its future dividends is equivalent to the value of the company.
Capital Gains Yield
It may be referred to as the earnings generated on an investment over a particular period of time. It is generally expressed as a percentage and includes some dividends or interest earned by holding a particular security. Cases, where it is higher normally, indicate the higher income and lower risk. It is mostly computed on an annual basis and is different from the total return on investment. In case it becomes too high, indicates that either the stock prices are going down or the company is paying higher dividends.
Stock Valuation
In simple words, stock valuation is a tool to calculate the current price, or value, of a company. It is used to not only calculate the value of the company but help an investor decide if they want to buy, sell or hold a company's stocks.
Am I calculating the Required Return corrrectly using basic algebra? As I see it the investors are requring a return = 10%.
![EXAMPLE 12.1 The Cost of Equity
Suppose stock in Alpha Air Freight has a beta of 1.2. The market risk premium is 8 percent, and the
risk-free rate is 6 percent. Alpha's last dividend was $2 per share, and the dividend is expected to
grow at 8 percent indefinitely. The stock currently sells for $30. What is Alpha's cost of equity
capital?
We can start off by using the SML. Doing this, we find that the expected return on the common.
stock of Alpha Air Freight is:
R₂=R₁+B₂X (R-R)
= 6% +1.2 x 8%
<= 15.6%
This suggests that 15.6 percent is Alpha's cost of equity. We next use the dividend growth model.
The projected dividend is D. x (1 + g) = $2 x 1.08 = $2.16, so the expected return using this
approach is:
R=D/P+g
= $2.16/30+.08
= 15.2%
Our two estimates are reasonably close, so we might just average them to find that Alpha's cost of
equity is approximately 15.4 percent.
O
EXAMPLE 12.1 page 394
Rm 8%
R$ = 6₂%
Po F #3
९
- 8%
= 30
0 JmL = Security market Line
RE= RF + [8 (Rm-RF)
= 0 + [ 1.2 (108)
=
L
+ [
J
= 6.136
= 115.6%
2 Div Reinvest model
مان
R= Po
=
3 Aug
9
+08
.066 +.08
152
15.2 %
2:16
36
T
15.6
2 x 1.08 2.16
SML
DRM
15.2
WACC
weighted Aug Cost of Capital = 15,4%
= what the company must earn to compensate their
investors for their money
] - 15.4%
Rm = market risk premium_
annoted as
Rm-RF
.08 - Rm - 02
·10 = Rm = Required Return
O
O
O
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