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Calculating the Cost of Equity

You are an analyst in the financial division of Flipper Industries (FI) which has a beta of 1.80 (you are risk-philic, so you enjoy the thrill of working somewhere so risky). The company just paid a dividend of $1 and dividends are expected to grow at 5% per year. The expected return on the market is 11% and Treasury Bills are yielding 3%. The most recent stock price for FI is $60. Your boss asks you to calculate the cost of equity.

a. Calculate the cost of equity using the Dividend Discount Model

b. Calculate the cost of equity using the SML

c. How do you explain the difference between the two calculations to your boss? You can be brief – he’s in a hurry.

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