The CFO of Lenox Industries hired you as a consultant to help estimate its cost

Question

The CFO of Lenox Industries hired you as a consultant to help estimate its cost of capital. You have obtained the following data: () rd - yield on the firm's bonds - 7.00% and the risk premium"over its own debt cost 4.00%. (2) rRF 5.00%, RPM- 6.00%, and b-# 1.50. (3) D1-$1.20, P0-$35.00, and g 8.00% (constant). You were asked to estimate the cost of equity based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference?

Explanation / Answer

1)Cost of equity using bond yield plus risk premium =Debt yield + risk premium

       = 7+ 4

       = 11%

2)cost of equity using CAPM = Rf+ [RPM*b]

       = 5+ [6*1.5]

         = 5 + 9

         = 14%

3)cost of equity using dividend discount model = [D1/price ] +g

                =[1.2 / 35 ] + .08

               = .0343+.08

                 = .1143 or 11.43%

Difference between lowest and highest = 14-11 = 3%

correct option is "A"

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