10-5: The Cost of Retained Earnings, rs Problem Walk-Through Cost of Common Equi

Question

10-5: The Cost of Retained Earnings, rs Problem Walk-Through Cost of Common Equity The future earnings, dividends, and common stock price of Carpetto Technologies Inc. are expected to grow 5% per year. Carpetto's common stock currently sells for $29.25 per share; its last dividend was $1.60; and it will pay a $1.68 dividend at the end of the current year. a. Using the DCF approach, what is its cost of common equity? Round your answer to two decimal places 10.74 096 b. If the firm's beta is 1.40, the risk-free rate is 496, and the average return on the market is 13%, what will be the firm's cost of common equity using the CAPM approach? Round your answer to two decimal places. 16.6 % c. If the firm's bonds earn a return of 8%, based on the bond-yield-plus-risk-premium approach, what will be rs? Use the midpoint of the risk premium range discussed in Section 10-5 in your calculations. Round your answer to two decimal places. 30% d. If you have equal confidence in the inputs used for the three approaches, what is your estimate of Carpetto's cost of common equity? Round your answer to two decimal places.

Explanation / Answer

Price=D1/(r-g)
29.25=1.68/(r-0.05)
Hence, r=1.68/29.25+0.05=10.74%

CAPM says cost of equity=risk free+beta*(market return-risk free)=4%+1.4*(13%-4%)=16.6%

cost of equity=bond yield+risk premium=8%+4%=12%

Cost of equity=(10.74+16.6+12)/3=13.1133%

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