The earnings, dividends, and common stock price of Carpetto Technologies Inc. ar
ID: 2663926 • Letter: T
Question
The earnings, dividends, and common stock price of Carpetto Technologies Inc. are expected to grow at 5% per year in the future. Carpetto's common stock sells for $28.50 per share, its last dividend was $2.00, and it will pay a dividend of $2.10 at the end of the current year.a. Using the DCF approach, what is its cost of common equity? Round your answer to two decimal places.
b. If the firm's beta is 2.10, the risk-free rate is 4%, and the average return on the market is 12%, what will be the firm's cost of common equity using the CAPM approach? Round your answer to two decimal places.
c. If the firm's bonds earn a return of 9%, what will rs be based on the bond-yield-plus-risk-premium approach, using the midpoint of the risk premium range as suggested in studies? Round your answer to two decimal places.
d. Assuming you have equal confidence in the inputs used for the three approaches, what is your estimate of Carpetto's cost of common equity? Round your answer to two decimal places.
Explanation / Answer
a) The formula for calculating the cost of equity using DCF approach is Ke = (D1/P0) + g Where Ke is the cost of common equity D1 is the Dividend in the year-1 = $2.10 P0 is the price of the share = $28.50 g is the growth rate = 5% Substituting the values in the above formula, we get Ke = ($2.10 / $28.50) + 0.05 = (0.0737) + 0.05 = 0.1237 or 12.37% b) The formula for calculating the cost of equity using CAPM approach is Ke = Rf + Beta [E(Rm) - Rf] Where Rf is the risk-free rate = 4% E(Rm) is the expected market return = 12% beta is 2.10 By substituting the values in the above equation, we get Ke = 0.04 + 2.10 [ 0.12 - 0.04] = 0.04 + 2.10 [0.08] = 0.04 + 0.168 = 0.208 or 20.8% c) Some analysts use subjective ad hoc procedure to estimate a firm's cost of common equity. They simply add a judgemental risk premium of 3 to 5 percentage points to the interest rate on the firm's own long-term debt. it is logical to think that firm's with risky, low-rated and consequently high-interest rate debt will also have risky, high-cost equity and the procedure of basing the cost of equity on a readily observable debt cost utilizes this logic. In this approach, rs = Bond yield + Bond risk premium The bond have a yield of 9% . If the bonds risk premium is estimated as 3.7% then its estimated cot of equity is rs = 9% + 3.7% = 12.7% Becasue the 3.7% risk premium is a judgemental estimate, the estimated value of rs is aslo judgemental. d) We have discussed three methods for estimating the cost of common equity. Based on the discussion, the DCF approach estimate is 12.37% , the CAPM estimate is 20.8% and the Bond-yield -plus-risk premium is 12.7%. The overall average of these three methods is (12.37 + 20.8 + 12.7) / 3 = 15.29% These results are unusually consistent, so it woul make little difference. But the methods produced widely varied estimates and as most of the repondents use the CAPM approach, we use the CAPM to make a judgemental analysis. People experienced in estimating the cost of equity recognizes that both creful analysis and sound judgement are required.
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