Earnings are expected to grow at a rate of 6% for the next three to five years. The returns on Donaldson common stock and those of the market for each of the past 24 months are:

Donaldson’s management is interested in calculating the firm’s cost of capital. A key ingredient in this cost is the cost of equity.

a. Estimate the cost of equity capital for the Donaldson Corporation using the dividend valuation model. List all assumptions.

b. Estimate the cost of equity capital for the Donaldson Corporation using the capital asset pricing model. List all assumptions.

c. Which model is most appropriate in estimating Donaldson’s cost of equity? Support your choice.

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Return on Return Return on Return Donaldson on the Donaldson on the Month Stock Market Month Stock Market 1/02 +1.0% +1.5% 1/03 +1.2% +2.0% 2/02 +0.5 +0.75 2/03 +0.5 +0.8 3/02 -0.5 -0.70 3/03 -0.5 -0.7 4/02 +0.5 +0.7 4/03 +0.5 +0.7 5/02 -0.3 -0.3 5/03 -0.2 -0.3 6/02 +0.2 +0.1 6/03 +0.1 +0.1 7/02 +0.1 +0.1 7/03 +0.1 +0.1 8/02 -0.1 -0.5 8/03 -0.1 -0.4 9/02 0.0 +0.1 9/03 0.0 +0.1 10/02 -0.1 -0.2 10/03 -0.1 -0.1 11/02 +0.2 +0.1 11/03 +0.2 +0.1 12/02 -0.1 -0.1 12/03 -0.1 0.0