Stock in Country Road Industries has a beta of 1.62. The market risk premium is 8.2 percent while T-bills are currently yielding 2.9 percent. Country Road's last paid annual dividend was $1.87 per share and dividends are expected to grow at an annual rate of 3.8 percent indefinitely. The stock sells for $25 a share. What is the estimated cost of equity using the average return of the CAPM and the dividend discount model?

13.87%

Explanation:

Fristly, we calculate the cost of equity using capital asset pricing model:

Cost of equity_1 = Risk-free rate + Beta x Market risk premium

= 2.9% + 1.62 x 8.2% = 16.18%

(Note: T-bill yield is used as a proxy for risk-free rate).

Secondly, we find the implied cost of equity using dividend discounted model:

Stock price = Next year dividend / (Cost of equity_2 - Long term dividend growth) or:

25 = 1.87 x (1 + 3.8%) / (Cost of equity_2 - 3.8%). Solve the equation, we get: Cost of equity_2 = 11.56%

So the average cost of equity of the two method is (16.18% + 11.56%) / 2 = 13.87%.