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PROBLEM - An analyst estimates (after tax) the cost of debt capital for ABC is 3.5% and that its cost of equity capital is 5.0%. Assume that ABC's tax rate is 21%, the risk-free rate is 2.1%, the market risk premium is 5%, the ABC market price is $85 per common share, and its dividends are $1.30 per common share.
a) Estimating WACC and DDMa)Compute ABC's average pretax borrowing rate and its market beta.
b) Assume that its dividends continue at the current level in perpetuity. Use the constant perpetuity DDM and the market price to infer the market's expected cost of equity capital.
c) Compare the inferred cost of equity capital from part b to the 5.0% estimated cost of equity capital from the analyst. Comment on any difference.
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