Question

Eaton Electronic Company’s treasurer uses both the capital asset pricing model and the dividend valuation model to compute the cost of common equity (also referred to as the required rate of return for common equity).

Assume:

Rf	=		5	%
Km	=		10	%
β	=		1.7
D1	=	$	0.40
P0	=	$	19
g	=		9	%

  
a. Compute K_i (required rate of return on common equity based on the capital asset pricing model). (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  

b. Compute K_e (required rate of return on common equity based on the dividend valuation model). (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  

Answer 1

Part A:

Ke = Rf + Beta [ Rm - Rf ]

= 5% + 1.7 [ 10% - 5% ]

= 5% + 1.7 [ 5% ]

= 5% +8.5%

= 13.5%

Part B:

Ke = [ D1 / P0 ] + g

= [ 0.40 / 19 ] +0.09

= 0.0211 + 0.09

= 0.1111 i.e 11.11%

As per CAPM - 13.5%

As per Div growth Model 11.11%