1 Finance 351: Financial Management Instructor: Shuming Liu In-Class Exercise 9 Solution to Minicase for Chapter 13 Bernice needs to explain to her boss, Mr. Brinestone, that appropriate rates of return for cost of capital calculations are the rates of return that investors can earn on comparable risk investments in the capital market. Mr. Brinestone’s estimate of the cost of equity is his target value for the book return on equity; it is not the expected rate of return that investors demand on shares of stock with the same risk as Sea Shore Salt. Bernice’s CAPM calculation indicates that the correct value for the equity rate is 10.5%. This value is broadly consistent with the rate one would infer from the constant growth dividend discount model (which seems appropriate for a mature firm like this one with stable growth prospects). The dividend discount model implies a cost of equity of a bit more than 11 percent: r equity % 7 . 11 117 .0 067 .0 40
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This note was uploaded on 11/18/2011 for the course FIN 351 taught by Professor Li during the Fall '09 term at S.F. State.