ABC Company is currently paying an annual common stock dividend of Rs. 3.30 per

share. The company’s dividend has grown gradually over the past nine years from Rs.

1.65 to its current level; this growth is expected to continue. The company’s present

dividend payout ratio, also expected to continue, is 40 percent. Moreover, the stock

presently sells at 8 times the current earnings.

ABC Company stock has a beta of 1.15, as computed by a leading investment advisory.

The present risk-free rate is 10.50 percent, and the expected return on the stock market

is 13 percent.

**a. Calculate the ABC’s cost of equity capital using both the Dividend Discount Model approach and Capital Asset Pricing Model approach.**

**Solution: **

Cost of Equity Capital = RE = wacc-RDXD / XE

Where,

Wacc = weighted average cost of capital

RDXD = weighted % cost of bond

XE = weighted or fraction of total capital raised from common equity.

Capital Asset Pricing Model approach:

**Ans**:13.375%

**b. Suppose you as an individual investor feel that 12 percent is an appropriate ****required rate of return for the level of risk you perceive for ABC Company. Using ****the dividend discount model and Capital Asset Pricing Model approaches, ****determine whether you should purchase ABC Company stock or not.**

**c. ABC Company has estimated the various costs of debt for different proportions of debt in its capital structure; you are required to determine the firm’s optimal capital structure.**

Proportion of Debt Cost of Debt

0 11.00%

25% 11.40%

50% 11.80%

75% 12.50%

100% 13.00%

Note: use cost of equity as calculated under Dividend Discount Model for part c.

**Solution:**