Common stock issued by Meggitt Sensing Systems paid stockholders an initial dividend of $0.93 per share on an average price of $18.80 last year. The company expects to grow the dividend rate at a maximum of 1.5% per year. The stock volatility is 1.19, and other stocks in the same industry are paying an average of 4.95% per year dividend. U.S. Treasury bills are returning 2.0%. Determine Meggitt’s cost of equity capital last year using (a) the dividend method, and (b) the CAPM. (c) To what amount could the initial year dividend have decreased before the CAPM estimate would have exceeded the dividend method estimate?
What will be an ideal response?
(a) Dividend method: Re = DV1/P + g
= 0.93/18.80 + 0.015
= 0.0644 (6.44%)
(b) CAPM: (The return values are in percent)
Re = Rf + ?(Rm - Rf)
= 2.0 + 1.19(4.95 – 2.0)
= 5.51%
CAPM estimate of cost of equity capital is lower.
(c) Set dividend method Re = 0.0551 and solve for DV1
0.0551 = DV1/18.80 + 0.015
DV1 = 18.80(0.040)
= $0.754
For any initial dividend less than 75.4¢ per share, the CAPM estimate will be larger.
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