12. The CFO of Lenox Industries hired you as a consultant to help estimate its c
ID: 2666203 • Letter: 1
Question
12. The CFO of Lenox Industries hired you as a consultant to help estimate its cost of capital. You have obtained the following data: (1) 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 = 1.25. (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?a. 1.13%
b. 1.50%
c. 1.88%
d. 2.34%
e. 2.58%
Explanation / Answer
Bond Yield Plus Risk Premium = 7% + 4% = 11% CAPM = Rf + Rpm * Beta CAPM = 5% + 6%*1.25 = 12.5% DCF (we need to do some rearranging to solve this one); P0 = D1/(r-g) 35 = 1.2 / (r - 0.08) 35 * (r - 0.08) = 1.20 r - 0.08 = 1.2 / 35 r = (1.2 / 35) + 0.08 = 11.4285% Highest is CAPM at 12.5% Lowest is Bond Yield Plus Risk Premium at 11% Difference is 1.5%, choice B
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