The company has a target capital structure of 40% debt and 60% equity. Bonds pay 10% coupon (semi-annual payout), mature in 20 years, and sell for $849.54. The company stock beta is 1.2. The risk-free rate is 10%, and the market risk premium is 5%. The company is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8%. The company's marginal tax rate is 40%. The cost of equity using the capital asset pricing model (CAPM) and the dividend discount model (DDM) is:

Dividend discount model (DDM) is a method of calculating the cost of equity. The formula is as follows;

cost of equity; r = (D1/P0) + g

whereby, D1 = next year's dividend

P0 = Current price of the stock = 27

g = the stock's dividend growth rate = 8% or 0.08 as a decimal

D1 = D0 (1+g)

D1 = 2 (1+0.08) = 2.16

Next, plug in the numbers to the formula

r = (2.16/27) + 0.08

r = 0.08 + 0.08

r = 0.16 or 16%

Cost of equity using CAPM

CAPM is Capital asset pricing model. It is also used to estimate the cost of equity.

CAPM; r = risk free + beta (market risk premium)

r = 0.10 + 1.2 (0.05)

r = 0.10 + 0.06

r = 0.16 or 16%

Therefore, DDM and CAPM give the same cost of equity.