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:
RE =Rf+ßE ×(RM -Rf )
=6%+1.2×8%
=15.6%
This suggests that 15.6 percent is Alpha's cost of equity. We next use the dividend growth model. The projected dividend is D0 ×(1+g) =$2 ×1.08=$2.16, so the expected return using this approach is:
RE =D1/P0+g
=$2.16/30 +.08
=15.2%
Our two estimates are reasonably close, so we might just average them to find that Alpha's cost of equity is approximately 15.4 percent.
CONCEPT QUESTIONS
a What do we mean when we say that a corporation's cost of equity capital is 16 percent?
b What are two approaches to estimating the cost of equity capital?