Firm Axios has earnings per share of $4, stock price of $32 /share and, hence, a P/E ratio of 8 [the P/E ratio is the Price per share divided by the earnings per share] today i

Finance May 09, 2021

Firm Axios has earnings per share of $4, stock price of $32 /share and, hence, a P/E ratio of 8 [the P/E ratio is the Price per share divided by the earnings per share] today i.e., T=O. The firm's annual dividend for year T=0 has just been paid out (and, therefore, is not reflected in the current stock price of $32). The firm's earnings are expected to keep growing at a rate of 6%. The firm follows a policy of always paying 1/2 of its earnings in annual dividends (and reinvesting the rest).
Question: What is your estimate of the firm's cost of equity capital?

Expert Solution

Computation of the cost of equity capital:-

E1 = E0*(1+growth rate)

= $4 * (1 + 6%)

= $4.24

D1 = E1 * 1 / 2

= $4.24 * 1 / 2

= $2.12

Cost of equity = (D1 / Current stock price) + Growth rate

= ($2.12 / $32) + 6%

= 6.63% + 6%

= 12.63%

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