Example 151 I

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:

4Beta coefficients can also be estimated directly by using historical data. For a discussion of how to do this, see Chapters 9, 10, and 11 in S. A. Ross, R. W. Westerfield, and J. J. Jaffe, Corporate Finance, 6th ed. (New York: McGraw-Hill, 2002).

Ross et al.: Fundamentals VI. Cost of Capital and 15. Cost of Capital of Corporate Finance, Sixth Long-Term Financial Edition, Alternate Edition Policy

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