The CFO of Lenox Industries hired you as a consultant to help estimate its cost
ID: 2796176 • Letter: T
Question
The CFO of Lenox Industries hired you as a consultant to help estimate its cost of capital. You have obtained the following data: (1) rd = yield on the firm's bonds = 7.00% and the risk premium over its own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.50. (3) D1 = $1.20, P0 = $35.00, and g = 8.00% (constant). You were asked to estimate the cost of equity based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference?
Explanation / Answer
According to (1) which is bond yield plus risk premium cost of equity = 7+4%=11%
According to 2 which is CAPM, return = Rf+(Beta*RPM)=5+1.5*6=14%
According to 3 which is dividend discount model rate = D1/P0+g=1.20/35+0.08=11.43%
Highest estimate is according to CAPM=14%
Lowest estimate according to bond yield plus risk premium = 11%
Difference = 14-11%=3%
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