Po pected g Investors expect to receive a dividend yield, . plus a capital gain,
ID: 2786389 • Letter: P
Question
Po pected g Investors expect to receive a dividend yield, . plus a capital gain, Q. for a total expected returm. In ehs expetelreturn i aBl equal to te nqsd return. It's easy to calculate the dividend yield; but because stock prices fluctuate, the yield varies from day to day, which leads that ations in the peastofeo Also, it is difficult to determine the proper growth especially if past growth rates are not expected to continue in the future. However, we can use growth rates as projected by security analysts, who regularly forecast growth rates of earnings and dividends. which method should be used to estimate r? If managemen weighted average of the three methods. Judgment is important and comes int in one method, it would probably use that method's estimate. Otherwise, it might use some o play here, as is true for most decisions in finance. Problem: Barton Industries estimates its cost of common equity by using three approaches: the CAPM, the bond-yield plus-risk-premium approach, and the DCF model Barton expects next year's annual div end, D, to be $1.60 and it expects dividends to grow at a constant rate g-3.7%. The firm's ament common stock price, por is $25.00. The current risk-free rate, rR, 4%; the market risk premium, RP -5.3%, a d the finn's stock has a arret beta b,-LL As me thithe cost of debt, ra is 6.6796. The firm uses a 3.3% risk premium when arriving at a ballpark estimate of its cost of equity usin the brd-yee pus isk premiumappr ch. What is the firm's cost of equity using each of these three approaches? Round your answers to 2 decimal places CAPM cost of equity: 3s% Bond yield plus risk premium DCF cost of equity: What is your best estimate of the firm's cost of equity? The best estimate is the average of the three approaches ocatorz assignment-take pps.ng.cengage.com/ilrn/takeAssignment/takeAssignmentMain.dotakExplanation / Answer
1.
Cost of equity using CAPM
Cost of equity = 4% + (5.30% × 1.10)
= 4% + 5.83%
= 9.83%
Cost of equity using CAPM model is 9.83%.
Cost of equity using DDM model
Cost of equity = (Expected Dividend / Current price) + Growth rate
= ($1.60 / $25) + 5%
= 6.40% + 5%
= 11.40%
Cost of equity using DCF model is 11.40%.
Cost of equity using bond yield and risk premium
Cost of equity = Bond Yield + Risk premium
= 6.67% + 3.30%
= 9.97%
Cost of equity using bond yield and risk premium is 9.97%.
CAPM model is considered as best estimate of cost of equity because is consider risk free rate, market risk premium and risk of specific firm (Beta)
So cost of equity is 9.83%.
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