The earnings, dividends and stock prices are expected to grow at 7% per year in

Question

The earnings, dividends and stock prices are expected to grow at 7% per year in the future. Common stock sells for $23 per share its last dividend was $2.00 and the company will pay a dividend of $2.14 at the end of the current year.
-a. using the discounted cash flow approach, what is the equity?
b. the firm's beta is 1.6 the risk free rate is 9% and the expected return on the market is 13% what will be the firm's cost of equity using the CAPM approach?
c. firm's bonds earn a return of 12% what will rs be using the bond-yield-plus-risk-premium approach?
d. on the basis of the results of the first three parts what would the estimate of the cost of equity be?

Explanation / Answer

(a) Using the DCF approach, what is the cost of common equity? Cost of common equity Ke = D1/P0 +g D1 = 2.00 (1 + 0.07) = 2.14 Ke = 2.14/23 + 0.07 = 16.30% (b) If the firm's beta is 1.6, the risk-free rate is 9 percent, and the average return on the market is 13 percent, what will be the firm's cost of common equity using the CAPM approach? Required rate of return = Risk free rate + beta x Market risk premium = 9% + 1.6 (13% - 9%) = 15.4% (c) If the firm's bonds earn a return of 12 percent, what will rs be based on the bond-yield-plus-risk-premium approach, using the midpoint of the risk premium range? Rs= Bond yield + Risk premium =12%+4% =16% (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? It is difficult to estimate beta and also growth rate has to be assumed to be constant. Thus bond-yield plus risk premium approach is appropriate to calculate cost of equity. Cost of common equity Ke = D1/P0 +g =(2.14)/23+7% =16.3%

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