(c) The cost of equity can be calculated using two techniques: the capital asset pricing model, and
the dividend valuation model.
The capital asset pricing model uses the beta factor of a company to measure its risk; a beta
factor reflects the volatility of the company’s share price against the stock market. Since Eton
does not have a share price (it is not listed) it cannot have a beta and therefore cannot use this
model.
The dividend valuation model uses the following formula:
One of the variables in this formula is P0 i.e. the current share price, so again Eton cannot use
this as it does not have a share price.
The use of industry averages is therefore common for unlisted companies, but this brings its own
difficulties. The industry average of 15% reflects the return required to compensate investors for
the overall average risk levels that they face.
If Eton is a high growth/high risk business then its shareholders would expect a higher rate of
return and therefore the Ke of 15% used in part (a) would result in an overvaluation of Eton Co.
If Eton is a low growth/ low risk business then its shareholders would expect a lower rate of return
and therefore the Ke of 15% used in part (a) would result in an undervaluation of Eton Co.
