LaForge\'s common stock is currently selling for $50 a share. Its last dividend

Question

LaForge's common stock is currently selling for $50 a share. Its last dividend was $4.19, and dividends are expected to grow at a constant rate of 5% in the forseeable future. LaForge's beta is 1.2, and its yield on a T-bond is 5%, and the market risk premium is estimated at 5%. For the bond yield plus risk premium approach, use a maximum risk premium.

What is LaForge's estimated cost of common equity based on the CAPM approach?

What is LaForge's estimated cost of common equity using the DCF approach?

What is the bond yield plus risk premium estimate to LaForge's cost of common equity?

Explanation / Answer

What is LaForge's estimated cost of common equity based on the CAPM approach?

Answer:

We know that expected return E(R) by CAPM approach is:

E(R) = Rf + beta x risk premium

Here

Rf = 5%

Beta = 1.2

Risk premium = 5%

Therefore,

E(R) = 5% + 1.2 x 5% = 11%        this is the cost of equity.

What is LaForge's estimated cost of common equity using the DCF approach?

Answer:

By DCF approach cost of equity is:

Ke   =    D1 / MP    +   g%

Here,

Ke = cost of equity = ?

D1 = dividend at the end of a year

MP = Current market price of the share = $50

g% = growth rate in dividends = 5%

Now D1 = D0 (1+g%) = $4.19(1+5%) = $4.3995

Therefore,

Ke =   $4.3995/$50 + 5%   = 0.13799 or 13.799%

This is the cost of equity by DCF approach.

What is the bond yield plus risk premium estimate to LaForge's cost of common equity?

Answer:

Cost of equity = longterm bond yield + risk premium = 5% + 5% = 10%

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