Question: Equity Enterprises wants to estimate its cost of equity. The firm does not intend to issue new shares as retained earnings have proven adequate for the funding of new investments. At a recent meeting of the board of directors, a fair return on equity was judged to be 14 percent, subject to verification by the finance department. As a financial executive, you are reviewing this figure based on the following additional information: Current interest rates on long-term government bonds are 9 percent. Historically, market returns have exceeded the riskfree rate by 5 to 7 percent. Although you do not have a beta for your firm, the beta for a similar firm in the United States is published by an investment house.
Over the last few years, this beta has varied between 1 .3 and 1 .5. Earnings per share are currently $8, and current dividends are $4.80 per share. Over the last 6 months, the share price has fluctuated between $55 and $65. The average growth rate in dividends over the last 20 years has been 12 percent, which was about 2 percentage points higher than the average inflation rate. However, current interest rates seem to imply long-term inflation expectations of 5 to 8 percent. For the next directors' meeting, prepare a brief memorandum outlining your thoughts regarding the firm's costs of equity. How reasonable does the judgmentally derived cost of equity of 14 percent appear to be?