Question
ABC Ltd has a mix of equity and debt capital. The average maturity of ABC Ltd's debt is 5 years. You want to estimate ABC
ABC Ltd has a mix of equity and debt capital. The average maturity of ABC Ltd's debt is 5 years. You want to estimate ABC Ltd's cost of capital for valuation and need an estimate of the risk-free rate. You could choose the 5-year Australian Government Bond (3.25%) or the 10-year Australian Government Bond (2.50%).
Using available information about ABC Ltd, you estimate its cost of equity as 12%. This gives you a valuation of $34 per share. Since the current market price of ABC Ltd's share is $50, you conclude that it is under-valued. However, to be more confident of your valuation, you decide to estimate the implied cost of equity using the company's current share price and the dividend payout (assuming a constant growth in dividend). Suppose you estimate the implied cost of equity as 12.2%. What would your investment decision be? Use your understanding of the implied cost of equity to explain.
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