Stylejet is a hi fi audio systems maker. The CFO of stylejet has recieved the pr
ID: 2667588 • Letter: S
Question
Stylejet is a hi fi audio systems maker. The CFO of stylejet has recieved the preliminary balance sheet for the fiscal year 2009. Also the following information was available through internal departments.Assets
Market value of assets = $1000
Liabilities and shareholders equity
Market Value of Debt = $700
Market Value of Equity = $300
# The Statutory comapany tax rate is 30%
# The effective company tax rate is 15%
# All of stylejets debt is a commercial bill with 62 days to maturity with a face value of $710.
# All of stylejets equity is ordinary shares with a market price of $2 and expects a perpetual annual dividend of 17.5 cents per share, no franking credit was assigned to the dividends.
# Franking premium is 0.
# Risk free rate is 3%
# Expected return on the market is 10%
# Beta of stylejet shares is 1.2
c) Calculate the cost of equity using the dividend growth model.?
Explanation / Answer
Using CAPM, Cost of Equity Ke = Krf + Beta*(Km-Krf) ie Ke = 3% + 1.2*(10% - 3%) = 3% + 1.2*7% = 11.40%..........(1) Using Div grwoth model, We have Mkt Price of stock P0 = $2 & a D0 = $0.175 or 17.5% This is a perpetual dividend so growth rate g = 0 We have the equation in Div Growth model as P0 = D1/(Ks-g) where Ks is cost of equity. In given case, this reduces to P0=D0*(1+g)/(Ks-g) = D0/Ks as g=0 So we have Cost of EQuity Ks = D0/P0 = 0.175/2 = 8.75%.......(2) Both estimates of the cost of equity seem reasonable. If we remember the historical return on large capitalization stocks, the estimate from the CAPM model is about one percent higher than average, and the estimate from the dividend growth model is about one percent lower than the historical average, so we cannot definitively say one of the estimates is incorrect. Given this, we will use the average of the two, so: Avge Cost of equity = (11.40%+8.75%)/2 = 10.08%