Cost Of Common Equity For Hetterbrand Co

Cost Of Common Equity The Common Stock For The Hetterbrand Corporati

Cost of common equity The common stock for the Hetterbrand Corporation sells for $59.17, and the last dividend paid was $2.24. Five years ago the firm paid $1.54 per share, and dividends are expected to grow at the same annual rate in the figure as they did over the past five years. What is the estimated cost of common equity to the firm using the dividend growth model? (Round to 2 decimal places.) Hetterbrand's CFO has asked his financial analyst to estimate the firm's cost of common equity using the CAPM as a way of validating the earlier calculations. The risk-free rate of interest is currently 4.1 percent, the market risk premium is estimated to be 4.2 percent, and Hetterbrand's beta is 0.78. What is your estimate of the firm's cost of common equity using this method? (Round to 2 decimal places.) I need this problem solved in 30 minites.

Paper For Above instruction

The calculation of a company's cost of common equity is a fundamental component of financial analysis, crucial for valuation, investment decisions, and corporate finance planning. Two widely used approaches to estimate this cost are the Dividend Discount Model (DDM), specifically the Gordon Growth Model, and the Capital Asset Pricing Model (CAPM). This paper explores both methodologies by applying them to the case of Hetterbrand Corporation, a firm with specific stock price and dividend data, and estimates its cost of common equity through each method.

Introduction

The cost of equity represents the return that investors require for investing in a company's equity. It reflects market perceptions of risk and is a vital input for calculating the Weighted Average Cost of Capital (WACC). Accurate estimation ensures sound financial decision-making and valuation. The two primary models for estimating the cost of equity include the dividend growth model (DGM) and the CAPM. While the DGM uses dividend growth expectations and current stock prices, the CAPM relies on systematic risk (beta), the risk-free rate, and the market risk premium.

Application of the Dividend Growth Model

To compute the cost of equity using the dividend growth model, we apply the formula:

Re = (D1 / P0) + g

where D1 is the expected dividend next year, P0 is the current stock price, and g is the dividend growth rate.

Given data:

• Last dividend paid, D0 = $2.24
• Stock price, P0 = $59.17
• Dividends five years ago, D0 (five years ago) = $1.54

Calculating the Dividend Growth Rate

The dividends have grown from $1.54 to $2.24 over five years. Assuming constant growth, the growth rate g is calculated as:

g = [(D0 / D1)^{1/n}] - 1 (Note: D1 is the expected next year's dividend; thus, first we find D1)

Next year's dividend, D1, is:

D1 = D0 * (1 + g)

Alternatively, the growth rate g can be computed directly as:

g = (D0 / D_{five\_years\_ago})^{1/5} - 1

Applying the latter method:

g = \[(2.24 / 1.54)^{1/5}\] - 1 ≈ (1.4558)^{0.2} - 1 ≈ 1.075 - 1 = 0.075 or 7.5%

Expected Dividend Next Year (D1)

D1 = D0 (1 + g) = 2.24 (1 + 0.075) ≈ 2.24 * 1.075 ≈ 2.411

Calculating the Cost of Equity (Re) using DGM

Re = (D1 / P0) + g = (2.411 / 59.17) + 0.075 ≈ 0.04073 + 0.075 ≈ 0.11573 or 11.57%

Application of the Capital Asset Pricing Model (CAPM)

The CAPM formula for the cost of equity is:

Re = Rf + β(Rm - Rf)

where:

• Rf = risk-free rate = 4.1% or 0.041
• β = beta of Hetterbrand = 0.78
• Market risk premium (Rm - Rf) = 4.2% or 0.042

Calculation of Re via CAPM

Re = 0.041 + 0.78 * 0.042 = 0.041 + 0.03276 ≈ 0.07376 or 7.38%

Comparison and Conclusions

The dividend growth model estimates the firm's cost of equity around 11.57%, reflecting investors' required return based on expected dividend growth. Conversely, the CAPM suggests a lower estimate of approximately 7.38%, which underscores the different underlying assumptions and sensitivities of each model. The DDM may be more appropriate here, given direct dividend information, whereas CAPM brings systematic risk into consideration.

Implications for Financial Decision-Making

Understanding the discrepancies between these models aids financial managers in making well-informed capital structure decisions. A higher estimated cost from the DDM may imply greater market expectations for dividend growth, whereas the CAPM offers an assessment rooted in market risk sensitivities. Combining both approaches provides a comprehensive view, and companies often use a weighted average of these estimates to determine their overall cost of equity.

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