An analyst is evaluating the stocks of two companies for inclusion in the diversified portfolio that he manages for a pension fund. He wishes to use the price/earnings multiple (PE ratio) to compare the stocks. The analy

CS Professional · Financial, Treasury and Forex Management · PYQS · June 2017
An analyst is evaluating the stocks of two companies for inclusion in the diversified portfolio that he manages for a pension fund. He wishes to use the price/earnings multiple (PE ratio) to compare the stocks. The analyst has collected the following information about Company A and Company B: Particulars Company A Company B Historical and expected return on equity (ROE) 16% 11% Historical and expected dividend payout ratio 40% 40% Beta 1.35 1.05 The expected return on the market index is 11.5 percent and the expected risk-free return is 5.25 percent. You are required to calculate the Cost of Equity.

Answer & Explanation:

Cost of equity (k e ) = R f + β(R m - R f ) Where R f = Risk free return β = Beta of security R m = expected return on market index For Company A k e = 5.25 + 1.35(11.5 - 5.25) = 13.6875% For Company B k e = 5.25 + 1.05(11.5 - 5.25) = 11.8125%

Topics: Financial Management

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