5. Click here to read the eBook: The Cost of Retained Earnings, rs 6. Problem Wa

Question

5. Click here to read the eBook: The Cost of Retained Earnings, rs 6. Problem Walk-Through COST OF COMMON EQUITY The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 3% per year. Callahan's common stock currently sells for $23.00 per share; its last dividend was $2.00; and it will pay a $2.06 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. Do not round your intermediate calculations 8. 9. 10. 11.96 b. If the firm's beta is 1.00, the risk-free rate is 7%, and the average return on the market is 14%, what will be the firm's cost of common equity using the CAPM 12. approach? Round your answer to two decimal places 14.00 13. Oc. If the firm's bonds earn a return of 9%, 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. 15. 14.00 16. 17 d. If you have equal confidence in the inputs used for the three approaches, what is your estimate of Callahan's cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations 18. 13.98

Explanation / Answer

a. Formula to calculate the current share price by dividend discount model

Stock Price P = D1 / (k – g)

Where:

P = the current stock price = $23

D1 = dividend for next year =$2.06

k = required rate of return =?

g = growth rate of dividends =3% or 0.03

Therefore,

$23 = $2.06 / (k-0.03)

Or k = ($2.06/$23) +0.03 =0.1196 or 11.96%

b. If CAPM holds, we have following formula

Required rate of Return on stock = risk free rate + * (market return – risk free rate)

Where,

Risk free rate = 7%

Market return = 14%

And of stock =1

Putting all the values in the equation we can get

Required rate of Return on stock = 7% + 1 * (14% – 7%)

= 7% +7% = 14%

c. As per bond yield plus risk premium approach

rs = bond’s yield + equity risk premium

Where,

Bond’s yield = 9%

Equity risk premium = Market return - Risk free rate = 14% -7% = 7%

Therefore,

rs = 9% +7% = 16%

d. Give equal weightage (1/3) to above three approaches to calculate the cost of equity, therefore

Cost of equity = (1/3)*11.96% + (1/3)*14 % + ( 1/3)*16%

= 13.99%

Related Questions

Navigate

• Browse (All)
• Browse 5
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.