The earnings, dividends, and common stock price of Carlos Enterprises are expect

Question

The earnings, dividends, and common stock price of Carlos Enterprises are expected to grow a 6 percent per year in the future. Carlos’ common stock sells for $27.50 per share, its last dividend was $3.00 and it will pay a dividend of $3.18 at the end of the current year.

Using the DCF approach, what is its cost of common equity?

If the firm’s beta is 1.2 the risk-free rate is 7 percent, and the average return on the market is 12 percent, what will be the firm’s cost of common equity using the CAPM approach?

Explanation / Answer

Firm’s cost of common equity using the DCF approach:

= dividend for next year / current share price + growth rate

= $3.18(1 + 0.06) / $27.50 + 6%

= 3.3708 + 0.06

= 0.12 +0.06

= 18%

  Firm’s cost of common equity using the CAPM approach:

Ke= Risk free return + Beta(Market return - risk free return)

   = 7% + 1.2 ( 0.12 - 0.07)

   = 0.07 + 0.06

   = 13%

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