A large for profit group practice has dividends that are expectedto grow at a co

Question

A large for profit group practice has dividends that are expectedto grow at a constant rate of 7% per year into the foreseeablefuture. The firm's last dividend (D0) was $2, and its current stockprice is $23. The beta coefficient of the firm is 1.6; the rate ofreturn on 20-year T-bonds currently is 9%; the expected rate ofreturn is 13%. The firm's target capital structure calls for 50%debt financing, the interest rate required on the business's newdebt is 10% and its tax rate is 40%
1. Calculate the cost of equity estimate using the DCFmethod.
2. Calculate the cost of equity estimate using CAPM
3. On the basis of the answers from question 1 & 2, whatis the final estimate for the firm's cost of equity?




1. Calculate the cost of equity estimate using the DCFmethod.
2. Calculate the cost of equity estimate using CAPM
3. On the basis of the answers from question 1 & 2, whatis the final estimate for the firm's cost of equity?

Explanation / Answer

Given Data:

           Company’s Capital structures are --- 50% Debt Financing

                                                                  ---50% Equity Financing

           Cost of debt before tax = 10%

           Risk- free rate (R f) = 9%

           Expected Rate of Return (Rm) = 13%

Common stock beta = 1.6

           Tax rate = 40%

           Dividend Growth Rate (g) = 7%

           Last dividend (D0) = $2

           Expected Dividend (D1) = D0 (1+g)]

           Expected Dividend (D1) = $2 (1+0.07)

           Expected Dividend (D1) = $2.14

           Current Stock Price (P0) = $23

(1)

           Calculate the Cost of Equity (RE) Using DCFMethod:

                       RE = (D1 / P0) + g

                        RE = ($2.14 / $23) + 0.07

                       RE = 0.1630 (or) 16.30%

           Cost of Equity (RE) = 16.30%

(2)

Calculation of Cost of equity(RE):

       (usingCAPM)

Cost of equity (R E) = R f + B * (Rm – R f)

                                 = 9% + 1.6(13% - 9%)

                                 = 0.09 + 1.6* 0.04

                                 = 0.09 +0.064

                                 = 0.154 (or)15.40%

Cost of equity (R E) =15.40%

(3) Averaging the two:

           Cost of Equity (RE) = [(0.1540 + 0.1630) / 2]

           

Cost of Equity (RE) = 0.1585 (or)15.85%

Calculation Company’s after-tax cost ofdebt:

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